how to buy and sell apartment buildings

How to Buy andSell ApartmentBuildingsSecond Edition

Eugene E. Vollucci

Stephen E. Vollucci

John Wiley & Sons, Inc.

How to Buy andSell ApartmentBuildings

How to Buy andSell ApartmentBuildingsSecond Edition

Eugene E. Vollucci

Stephen E. Vollucci

John Wiley & Sons, Inc.

This book is printed on acid-free paper.

Copyright © 1993 and 2004 by Eugene E. Vollucci. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permissionof the Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,(978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requeststo the Publisher for permission should be addressed to the PermissionsDepartment, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have usedtheir best efforts in preparing this book, they make no representations or warrantieswith respect to the accuracy or completeness of the contents of this book andspecifically disclaim any implied warranties of merchantability or fitness for aparticular purpose. No warranty may be created or extended by sales representativesor written sales materials. The advice and strategies contained herein may not besuitable for your situation. The publisher is not engaged in rendering professionalservices, and you should consult a professional where appropriate. Neither thepublisher nor author shall be liable for any loss of profit or any other commercialdamages, including but not limited to special, incidental, consequential, or otherdamages.

For general information on our other products and services please contact ourCustomer Care Department within the United States at (800) 762-2974, outside theUnited States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books. For more information aboutWiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Vollucci, Eugene E., 1939–How to buy and sell apartment buildings / Eugene E. Vollucci, Stephen

Vollucci.—2nd ed.p. cm.

Includes index.ISBN 0-471-65343-8 (pbk. : alk. paper)

1. Apartment houses. 2. Real estate business. 3. Real estate investment.I. Vollucci, Stephen. II. Title.HD1390.5.V64 2004333.33′8—dc22

2003068780

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

➇

http://www.copyright.com

http://www.wiley.com

v

Contents

Preface xiii

1 An Investment Plan to Create Wealth 1

Discover Life’s Three Chronological Investment Periods 1A Winning Financial Plan up to Age 35 1Investing between the Ages of 35 and 50 2

Why It Is Mathematically Impossible to Become WealthyEarning 20 Percent per Year 2

The Best Financial Plan for You 2What It Takes to Become Wealthy 4The Best Investment Strategy over Age 50 6

Conquering Your Fears of Investing 6Become a Gold Medalist in Investing 7Summary 7

2 Why Real Estate Is Your Best Investment 9

Using Real Estate to Control Risks 9Effectively Reducing Your Taxes 10Leveraging That Works 10

ftoc.qxd 4/5/04 11:31 AM Page v

MANTESHWER

Typewritten Text

MANTESHWER

Typewritten Text

ebooksdownloadrace.blogspot.in

vi CONTENTS

Why Real Estate Investment Is “Smart” 10Real Estate versus All Other Real Estate Investments 10

Three Advantages Apartments Have over OtherTypes of Real Estate 12

The Building Size That Gives You the GreatestProfit Potential 13

Apartments—the Coming Bonanza for You 14Real Estate: The Shock Absorber 17Summary 17

3 The New Approach to Investing in the 21st Century 19

Foreclosures—The Big Illusion 19What They Don’t Tell You about Foreclosures 21

Why Apartments Are the Best Investment 22Working Smarter Not Harder 22

Become a Millionaire in Only Three Moves 23Group Investing 23

Step 1: Research 25Step 2: Decreasing the Group Size 28Step 3: Sole Investor 35

Summary 36

4 How to Effectively Employ Consultants 39

Advantages of a Team Approach 39Picking the Right Consultant 40

Beware of “Know It Alls” 41Getting the Most Out of Your Consultant 42

Controlling Fees 42Avoid Unnecessary Billings 42Protecting Yourself 43Fee versus Commission 43Keep Control 43

Your Key Consultant 44Finding a Good Property Manager 44Be Wary of “Mom-and-Pop” Operations 44Be Just as Wary of the “Giants” in the Field 44Procedure Manuals Are Critical 45What to Expect from Your Property Manager 45

ftoc.qxd 4/5/04 11:31 AM Page vi

CONTENTS vii

Controlling Property Management Fees 45Traps to Avoid in the Property Management Agreement 46

Finding the Best Attorney for You 47Structuring Contracts to Avoid Litigation 48

The Secret to Working with Accountants 48Getting the Most from the Escrow and Title Companies 49The Consultant Who Will Save You the Most Time and Money 49

An Effective Way to Save on Commissions 50Understanding How Multiple Listing Services Work 50

What to Tell the Building Inspector before an Inspection 50Saving Money Using an Appraiser 52Working with Loan Brokers 52Summary 53

5 Buying in the Right Place at the Right Time 55

Two Rules for Buying and Selling 55The Benefits of Bottom Fishing 55

The Key to Evaluating Locations 56Employment Trends 56Demographic Factors Affecting Apartments 56

Apartment Building Cycles 57The Five Phases of an Apartment Cycle 57

Master Apartment Economics 58All Markets Rebound Eventually 60

The Analytical Approach to Locating Good Areas 60Determining the Best Time and Place to Buy and Sell 61

Summary 65

6 Easy Steps to Locating Good Property 67

Starting Your Search for Quality Apartment Buildings 67Make the Lenders Work for You 68Use Motivation to Your Advantage 68The Secret of Working with Real Estate Licensees 68A Sample Advertisement for Buying Apartments 69A Good Source for Leads 69Using Acquisition Cards 70Getting Sellers to Talk to You 70

Reading a Set-Up Sheet 70Summary 77

ftoc.qxd 4/5/04 11:31 AM Page vii

viii CONTENTS

7 Writing an Offer That Will Be Accepted 79

When to Use the 80 Percent Rule 80Getting the Seller’s Attention 80

Use a Written Offer 80A Purchase Offer Designed for Success 81

Make Sure Your Contract Is Legally Binding 91When Dealing with Sellers, Only Go Around Once 92

Weak Buyers Market 93Strong Buyers Market 93

A Unique Acceptance Letter That Effectively Ties Up Property 93Critical Documents for Due Diligence 93

Summary 95

8 Highly Effective Techniques for Analyzing Properties 97

The Key Figure in Evaluating Investments 97A Sound Down-Market Strategy 98Analyzing Property 98

Qualified Appraisers 98Comparable Sales Data or “Comps” 99Gross Multiplier Approach 99Capitalization Rate Method 99Essentials of Property Analysis Software 120

The Internal Rate of Return to Aim For 122Revenue Assumptions That Make Sense 123Analyze Expenses Correctly 126Use the Feel-and-Touch Analysis 126Summary 127

9 How to Become an Outstanding Negotiator 129

The Most Effective Financing Strategies 131Take a Loan “Subject To” Rather Than Assuming It 131Protecting Yourself When Using an All-Inclusive

Trust Deed 131A Little Known Secret of the Lease Option 132

Who Benefits from Compounding Interest 132Avoiding Deficiency Judgments 132Determining the Cost of Your Loan 133Restrictive Covenants 133Stopping Late Mortgage Payments 133

ftoc.qxd 4/5/04 11:31 AM Page viii

CONTENTS ix

Adjusting Mortgage Payments to Produce Cash Flow 134Getting the IRS to Pay for Your Investment 134Working with Constant Change and Limitations 134Always Think of the Sale When Buying 135Price Strategies That Work 135

Figures Smart Investors Want to See 135Never Pay Taxes on Profits Again 136Avoiding Mistakes When Negotiating 136

Down Payment Strategies That Work 136Protecting Yourself When the Buyer Wants You to Pay for Repairs 137Why “As Is” Is Now “As Was” 138Possession before Escrow Closes—A Great Strategy for Whom? 138When You Should Avoid Raising Rents 138Avoiding Sales Tax Problems 139When to Close Escrow to Avoid Collecting Late Rents 139Beware of Independent Escrow Companies 139Reducing the Cost of Title Insurance 140Controlling Escrow Deposits 140Handling Counter Offers 140Handling Seller’s Remorse 141Summary 141

10 Managing Your Property Manager 143

The Objectives of a Good Management Plan 143Improving Physical Appearance 144Increasing Rental Income 145Reducing Operating Expenses 145Reducing Insurance and Property Tax Expenses 146Comparing Your Apartment’s Performance to

Other Complexes 146Property Manager’s Reports 146

Defining Income and Expense Classifications 147Qualifying for the Maximum Tax Write-Off 150

Establishing Active Participation 151Summary 152

11 Useful Strategies in Marketing Your Property 153

The Best Time to Sell Your Property 153Getting Your Property Ready for Sale 154Your Marketing Plan Can Be Individually Tailored 155

ftoc.qxd 4/5/04 11:31 AM Page ix

x CONTENTS

Choosing the Right Person to Market Your Property 155How Much You Should Pay a Real Estate Licensee 155

At What Point Do You Become Liable for Real Estate Commissions? 156Discover an Effective Way to Self-Market Your Property 156Making Your Note More Valuable 156Determining Selling Price 157

Conservative Set-Up Sheets Are Important 157Controlling Drive-By Inspections 158Keep Your Property Management Company Informed 158What to Do When Dark Clouds Appear on the Title Report 158Looking for Buyers 158A Successful Newspaper Advertisement 158Responding to an Offer 159

Protecting Yourself When Your Property Is Tied Up 159Determining If You Have a Real Buyer 160Getting Out of Any Contract Legally 160Closing the Sale with No Strings Attached 160Summary 161

12 The Internal Revenue Service’s Best Kept Secret 163

Ways to Lower Taxable Income 163Spreading Income over Time 164Spreading Income to Various Entities 164Group Income and Expenses 164

Increasing the Depreciation Deduction 165Converting Real Property into Personal Property 165Personal Property Items Found in Apartment Buildings 166

The Last Remaining Loophole That Survived Tax Reform 167Deducting Accrued Interest When You’re on the Cash Basis 168

The All-Events Test and Economic Performance 168Accounting Method 169Limitations 170

You Should Always Defer Paying Taxes 170How to Not Pay Any Taxes on Capital Gains 171Catch-Up Depreciation 171Landlord/Leasee Tax Strategies 172How to Make a Tax Deductible Gift 172Give the Boot to Boot 172Unlimited Real Estate Losses for Real Estate Professionals 173

ftoc.qxd 4/5/04 11:31 AM Page x

CONTENTS xi

Like-Kind Exchanges Include Leases 173Tax-Deferred Exchanges 173Reverse Exchanges 174Depreciating Land Cost 174Paying Capital Gains . . . A Good Strategy 175Summary 175

13 Introducing Tenants-in-Common Form of Ownership 177

Ownership Features That Provide Flexibility 177Ways to Save with a Tenants-in-Common Ownership 178Tax Impact of Tenants-in-Common Ownership 180

New Guidelines for Tenants-in-Common Interest 180The Number One Pitfall of Security Transactions 180Creating a Nonsecurity Transaction 181

Howey Test 181Risk Capital Test 184Williamson Test 185

A Novel Way to Market a Nonsecurity 186How to Tap an Unlimited Supply of Buyers 187Protect Yourself When Dealing with

Nonsecurity Transactions 187Participating in Profits without Ownership 189Summary 189

14 Gain Freedom from Lawsuits 191

Painting a True Picture of Litigation 191Protecting Yourself from Lawsuits 192

Warning Signs of a Fraudulent Conveyance 192Avoiding Fraudulent Conveyance 193Making Yourself Judgment Proof 193

The Uniform Fraudulent Conveyance Act 194Limited Liability Companies 197The Legal Basis for the Family-Limited Partnership 197Hampering Creditors 200

Paying Yourself without Paying the Creditors 200Eliminating or Reducing the Cost of Personal

Liability Insurance 201Stumbling Blocks of Creditors 201

ftoc.qxd 4/5/04 11:31 AM Page xi

xii CONTENTS

Negotiating a Settlement 202Protection from Creditors of Family-Limited Partnership 202Estate Planning 202Protecting Yourself from Existing Claims 203Asset Protection Plan Using a Foreign Trust 203

Summary 206

Glossary 207

Apartment Periodicals 217

Index 219

ftoc.qxd 4/5/04 11:31 AM Page xii

xiii

Preface

Over the years, we have discovered that there are three dangerous mis-conceptions or myths about real estate. These myths either cause peo-ple to make bad investment decisions or avoid real estate entirely. Thisbook is devoted to dispelling these roadblocks to investing in real es-tate and paving the way to becoming wealthy.

One hazardous myth involves cash flow. If you think you can becomewealthy in real estate with cash flow, you might as well be straighteningup the deck chairs on the Titanic. It simply is not going to happen. Theway you become wealthy in real estate is through appreciation.

You can become wealthier with cash flow, but only after you haveobtained a certain level of wealth. If you’re thinking about investing inrental property, you should have some degree of certainty what the ap-preciation will be. That is what this book is all about: Giving you theguidance you need to determine when and how much appreciationthere will be.

The second myth is that there are no more tax benefits. When thetax reform act was passed in 1986, it eliminated many real estate taxbenefits. Tax benefits happen to be the second most important reasonpeople invest in rental real estate. The most important reason is to makemoney. But tax benefits let the government pay for part of your invest-ment. Your return after taxes is much greater with tax benefits. RobertBruss, the national real estate syndicated columnist, in his 2003 Realty

xiv PREFACE

Tax Tips points out the additional tax benefits of exchanging your wayto tax-free wealth by the use of an Internal Revenue code 1031 tax de-ferred exchange. This book provides the most up-to-date strategies onnot only avoiding taxes on exchanges but also on outright sales.

The third myth involves location. You’ve heard the term location, lo-cation, location . . . and location is very important. But too many in-vestors confuse location with local. Investors tend to look at rentalproperties within a short driving distance of where they live. However,if there are no opportunities for appreciation in those areas, you shouldnot be looking locally. You should be looking at pockets of opportunityno matter where they exist. This book not only shows you where tobuy and sell apartment buildings, it also shows you how to determine“when” to make your purchase.

In this book, we recommend one type of property, a precise method-ology, and a practical philosophy. We won’t bore you with generalities.However, we do promise to teach you how to become wealthy. To thattask, we’re deeply committed.

It is important to note that as of the date of the printing of this book,there is significant real estate tax legislation in progress. To get the lat-est updates and more information, contact The Center for Real EstateStudies, at (800) 955-3135. We hope this book gives you the knowledgeto invest wisely and brings you good fortune.

ACKNOWLEDGMENTS

A book doesn’t happen by itself. I would like to extend my personalthanks to Mike Hamilton of John Wiley & Sons for his insight andcommitment to How to Buy and Sell Apartment Buildings; to others atWiley including Kimberly Vaughn, Linda Witzling, and MichelleBecker; and to Nancy Marcus Land, Brenda Hunter, and the rest of theteam at Publications Development Company.

EUGENE E. VOLLUCCI

STEPHEN E. VOLLUCCI

1

1An Investment Plan to Create Wealth

DISCOVER LIFE’S THREE CHRONOLOGICALINVESTMENT PERIODS

Our investment philosophy is based on an individual’s chronologicaltime line, which consists of three periods: (1) asset accumulation, (2)wealth building, and (3) asset conservation.

The financial journey through life’s time line starts at different lev-els, depending on whether you were born with a plastic or a silverspoon in your mouth. As you travel through your time line, your in-vestment options change. Knowing where you are and what optionsare available will help you make the right choices.

How and when you make these choices is what this chapter is allabout!

A Winning Financial Plan up to Age 35

The first chronological period of your life—mid-twenties to mid-thirties—should be devoted to accumulating assets and acquiring basicnecessities. When you’re just starting out, your assets are usually limited

c01.qxd 4/5/04 11:33 AM Page 1

2 AN INVESTMENT PLAN TO CREATE WEALTH

and the major portion of your income goes for the basic needs—food,clothing, and shelter.

This is the time to save, save, save! Amass as many investment dollarsas possible. Your approach to investing during this period should bethrough tax-deferred plans at work or Individual Retirement Accounts(IRAs). Your degree of risk should be moderate. Investments included inthis category are AAA corporate bonds, blue chip stocks, and growth-oriented no-load mutual funds.

Every effort should be made to purchase a home now. The advan-tages, from tax savings and equity buildup, historically outweigh theshort-term benefits of lower monthly rent payments.

Be careful when sheltering yourself and your family from liability.Only pay for protection when you’re purchasing life insurance. Pur-chase whole life insurance if it will yield a higher rate of return thanother investments. After reading the chapter on asset protection, youmight seriously consider reducing your liability coverage.

Remember, your main financial goal during this time is tax-deferredaccumulation of capital. Don’t take risks with your investments. Save asmuch as you can so that when you enter the next phase of the time lineyou’ll be ready to move forward.

Investing between the Ages of 35 and 50

After earnings have increased, assets have been accumulated, andbasic necessities are under control, it ’s time to move on. Ready or not,you must face the challenges during this aggressive investment periodof your life, when you are between your mid-thirties and early fifties.

WHY IT IS MATHEMATICALLY IMPOSSIBLE TOBECOME WEALTHY EARNING 20 PERCENT PER YEAR

Aggressive investments are designed to create maximum wealth whilecontrolling risks. The value of these investments must increase sub-stantially for you to become wealthy. Investing $6,000 at 20 percentsimply isn’t going to do it. After taxes and inflation, mathematicallyit’s impossible. Look at Table 1.1 to see the data that is summarized inFigure 1.1.

The Best Financial Plan for You

Your best financial plan is to create the maximum wealth during thisaggressive investment period of your life. Build financial security

c01.qxd 4/5/04 11:33 AM Page 2

3

Table 1.1 Number of years to amass the purchasing power of a millionaire.

Inflation Rate

Year 3% 5% 7%

46 565,191 216,761 81,45447 623,892 234,340 86,20648 688,689 253,345 91,23549 760,216 273,892 96,55850 839,172 296,104 102,19151 926,329 320,118 108,15352 1,022,537 346,080 114,46253 374,147 121,14054 404,490 128,20755 437,294 135,68756 472,759 143,60357 511,100 151,98158 552,550 160,84759 597,362 170,23160 645,808 180,16261 698,183 190,67362 754,805 201,79763 816,020 213,57064 882,199 226,02965 953,746 239,21666 1,031,095 253,17267 267,94268 283,57369 300,11770 317,62671 336,15672 355,76873 376,52374 398,48975 421,73776 446,34177 472,38178 499,94079 529,10680 559,97481 592,64382 627,21883 663,81084 702,53785 743,52386 786,90087 832,80788 881,39389 932,81490 987,23491 1,044,829

Inflation Rate

Year 3% 5% 7%

1 6,623 6,487 6,3502 7,311 7,013 6,7213 8,070 7,581 7,1134 8,909 8,196 7,5285 9,834 8,861 7,9676 10,855 9,580 8,4317 11,983 10,356 8,9238 13,227 11,196 9,4449 14,601 12,104 9,995

10 16,117 13,086 10,57811 17,791 14,147 11,19512 19,639 15,295 11,84813 21,679 16,535 12,53914 23,930 17,876 13,27115 26,416 19,326 14,04516 29,159 20,893 14,86517 32,188 22,588 15,73218 35,531 24,420 16,65019 39,221 26,400 17,62120 43,294 28,541 18,64921 47,791 30,856 19,73722 52,754 33,358 20,88823 58,234 36,063 22,10724 64,282 38,988 23,39725 70,958 42,150 24,76226 78,328 45,568 26,20627 86,463 49,264 27,73528 95,443 53,259 29,35329 105,355 57,579 31,06630 116,298 62,248 32,87831 128,376 67,297 34,79632 141,710 72,754 36,82633 156,428 78,655 38,97534 172,674 85,034 41,24935 190,608 91,930 43,65536 210,405 99,385 46,20237 232,257 107,446 48,89738 256,379 116,159 51,75039 283,007 125,580 54,76940 312,400 135,764 57,96441 344,846 146,775 61,34642 380,662 158,678 64,92543 420,197 171,547 68,71244 463,839 185,460 72,72145 512,013 200,500 76,964

Tax Rate: 31%, Rate of Return: 20%, Initial Investment: $6,000

Source: The Center for Real Estate Studies.

c01.qxd 4/5/04 11:33 AM Page 3


yourself. Don’t rely on others to do it for you. Many people who reliedon major banks and insurance companies for financial security endedup short when these institutions failed. The social security system willnot do much better.

You should be careful not to over diversify your assets or adopt a“hold-back” attitude. You must concentrate your assets into one or twoaggressive investments rather than spreading them out. Diversificationoften leads to ineffectiveness.

What if you fail during this period? What is your down side? If youconsider your ability to bounce back because of your age, the politicalclout of your generation, taxes, and inflation, the real risk is mini-mized. Make your aggressive investments now. As you get older, yourability to rebound declines. If you do not try at this stage in your in-vestment time line, you probably will never do it, and more impor-tantly, you will never know whether you could have made it.

What It Takes to Become Wealthy

Becoming wealthy requires taking “controlled” risks. If anyone tellsyou that they became wealthy without taking any risks, they either in-herited wealth or they won the lottery.

Figure 1.1 Number of years to amass the purchasing power of a millionaire.Source: The Center for Real Estate Studies.

Num

ber

of Y

ears

0

20

40

6052

66

Percent Inflation

91

80

100

3 5 7

c01.qxd 4/5/04 11:33 AM Page 4

WHY IT IS MATHEMATICALLY IMPOSSIBLE 5

If you’re afraid to take risks, don’t do it. Your mental health is farmore important than your financial health. However, not taking finan-cial risks becomes a risk in itself. No-risk investments have lower ratesof return. Higher rates of inflation and taxes will eventually cause youto lose with these types of investments.

If risk taking makes you feel vibrant and alive, go for it! Especiallyduring this exciting chronological period of your life.

Your ability to take risks depends on your financial and emotionalcapabilities. Financial capabilities are based on age, occupation, num-ber of dependents, health, investment knowledge, and net worth. Emo-tional capabilities refer to whether or not you can sleep after you’veinvested the $6,000. The quiz in Figure 1.2 tests your tolerance for tak-ing risks.

(Circle One)1. I prefer working on a commission basis. Yes No2. I have my car checked according to the maintenance schedule. Yes No3. I would invest in gold. Yes No4. I make my own decisions. Yes No5. I want to be self-employed. Yes No6. I like going to Las Vegas, Nevada. Yes No7. I would bet on a horse if I got a tip from someone I know. Yes No8. I prefer working for the government. Yes No9. I would invest in a venture capital firm. Yes No

10. I prefer investing in certificates of deposit. Yes No11. I like surprises. Yes No12. I make daily decisions that af fect other people. Yes No13. I own a sports car. Yes No14. I would rather play than watch sports. Yes No15. I have enough in the bank to carry me through 12 months. Yes No16. I have my attorney help me with my financial decisions. Yes No17. I own a vacation condominium. Yes No18. I like to go to dif ferent restaurants. Yes No19. I enjoy traveling. Yes No20. The challenge is the most important thing. Yes No21. I prefer investments that produce income rather than appreciation. Yes No22. I prefer to read. Yes No23. I would have been a Western pioneer. Yes No24. I exercise daily. Yes No25. I purchase investments with borrowed money. Yes No

SCORE: If you answered yes to 1, 3, 4, 5, 6, 7, 9, 11, 12, 13, 14, 17, 18, 19, 20, 23,24, 25, you have a very high tolerance for risk. If you answered yes to half of these,you have a moderate to low tolerance. You should assess your own score in light ofyour financial goals.

Figure 1.2 Measure your risk tolerance. Source: The Center for RealEstate Studies.

c01.qxd 4/5/04 11:33 AM Page 5


If you devote sufficient time and effort, you will be able to enjoy notonly the wealth-building period of your life, but you will be able to lookforward to the next chronological stage, the asset conservation period.

The Best Investment Strategy over Age 50

The asset conservation period usually starts in the early fifties and ex-tends until you’re “pushing up daisies.” Your investments should beprimarily in federal and state tax-free bonds. Your main goal is tax-freeincome and preservation of capital. Estate planning should be initiatedduring this phase of your life. Your investments can be diversified aslong as they are conservative and risk free.

By taking controlled risk in the previous period, you won’t have todepend financially on the government or relatives. You’ll be indepen-dently able to maintain yourself during this asset conservation periodof your life.

CONQUERING YOUR FEARS OF INVESTING

Often people do not succeed because of fear. Why do people have a fearof investing? Some people are afraid of making decisions because theycontinually feel they don’t have enough information. This is what iscalled “paralysis by analysis.” Subconsciously, they keep on wantingmore information to avoid making a decision. Make your decisionsbased on the information you have diligently gathered and on the trustyou have in yourself and others.

Do you have a fear of failure? If you do not act because you’re afraidof failure, you’ve lost your opportunity. Everyone fails at one time oranother. That’s part of being human. The only way to conquer this fearis to keep trying. It doesn’t matter how many times you fail. What mat-ters is that you just keep trying and never give up. This is what life isall about. This is how to get ahead.

Strange as it may seem, many people have a fear of becoming wealthy.They fear losing friends by moving to a different socioeconomic level,and they fear that others will only like them for their money. If you losefriends because you become wealthy, they weren’t true friends to beginwith. Real friends like and need you for what you are, not how wealthyyou are.

People coming from countries where the government maintainscomplete control over them from cradle to grave have difficulty dealingwith such freedom. Financial freedom works in the same way. Peopledon’t know what to do with their time or their money. There are toomany choices. They become confused and withdrawn. Just remember

c01.qxd 4/5/04 11:33 AM Page 6

SUMMARY 7

all the things you wanted to do and all the people you wanted to help.Take one day at a time and don’t make any major changes in yourlifestyle.

Expressing your fear of expanding your horizons by continually ad-hering to an ultra-conservative philosophy is self-limiting. Bargain shop-ping is a prime example. I’ve seen people spend countless hours savingpennies when they could have used the same time making dollars.Using your time and money to create wealth has limitless potential.Don’t get caught up in petty economics. Expend your valuable resourcesof time and money for more rewarding goals.

BECOME A GOLD MEDALIST IN INVESTING

The purpose of this investment philosophy is to make you extremelywealthy by taking controlled risks and aggressively concentratingyour resources. Make a firm commitment to succeed, the same that ismade by an Olympic gold medalist. If you’re willing to make thatcommitment, then the information in this book will help make thatgoal a reality.

In going for the top, you won’t have to quit your job. However, youshould be prepared to work at least half a day to accomplish your goals.How much is half a day? Well, when the CEO of a Fortune 500 companywas asked by a reporter how he accomplished so much, he responded,“I only worked half a day.” The reporter commented, “That doesn’tsound like much.” He said, “I agree with you. Twelve hours a day isn’tmuch work at all.” Seriously, you don’t have to work half a day. Workonly long enough to get the job done. You be the judge. I’ll give you thetools. You will make the sincere effort.

SUMMARY

Your net worth and financial goals will determine how and when youshould make your moves. Investments should be timed accordingly.

Financial independence means having enough money. It’s that sim-ple. Amass enough capital during the asset-accumulation period sothat you can aggressively invest during the wealth-building period toeliminate money worries while you’re in the asset-conservation pe-riod. It sounds elementary, and it is.

In his book, In Search of Excellence, Tom Peters noted that the best strat-egy for success is, “Ready, fire, and aim.” (As opposed to ready, aim,fire.) If you’re “ready,” then you’re ready to fire. Just get out and do it.Fine tune it later. Most people spend so much time aiming, they neverpull the trigger.

c01.qxd 4/5/04 11:33 AM Page 7

c01.qxd 4/5/04 11:33 AM Page 8

9

2Why Real Estate IsYour Best Investment

Years ago, I discovered that real estate was the best investment to con-trol risk and create wealth. The Real Estate Digest reports that seven outof ten millionaires made their money in real estate, and Forbes magazinestates that there is a three times greater chance of becoming wealthythrough real estate than with any other type of investment.

USING REAL ESTATE TO CONTROL RISKS

Real estate allows you to control your risk because you can actively par-ticipate in the decision-making process. Passive investments such asstocks don’t give you this opportunity. Movements in real estate val-ues are less erratic than in the stock market. Most people don’t under-stand the economic forces influencing the market. Since real estate isless volatile, it ’s easier to control and to understand.

Real estate is tangible. You can touch it, you’ve been exposed to it allyour life, and you can identify with it. As a result of this familiarity,you are better able to understand it.

MANTESHWER

Typewritten Text

ebooksdownloadrace.blogspot.in

10 WHY REAL ESTATE IS YOUR BEST INVESTMENT

Effectively Reducing Your Taxes

Real estate ownership continues to be the most popular form of invest-ment because of its potential for substantial tax savings. Since you areable to actively participate in the management of real estate, the InternalRevenue Service (IRS) currently allows qualifying individuals to writeoff up to $25,000 per year against salary and other income. No other in-vestment gives you this capability. In addition, you can defer paying in-come taxes on profits indefinitely by using tax-deferred exchanges.

Leveraging That Works

Real estate is the only major investment that gives you the ability to ac-quire ownership with very little money down. This degree of leverag-ing allows you to amplify profits by using other people’s money. Themore assets you are able to control, the more opportunities you haveto succeed.

The degree of leverage is calculated by dividing the total purchaseprice of the property by the amount of funds used to purchase it. Thus,if a down payment of $10,000 plus a $90,000 loan is used to purchase aproperty, a 10 to 1 leverage ratio has been achieved.

The greater the leverage, the more equity will increase or decreasewith the change in value of the property. The affects of leverage areshown in Figure 2.1. Notice that at 20 percent appreciation, it takesseven times longer to double net equity using no leverage compared tousing a 10 to 1 ratio.

WHY REAL ESTATE INVESTMENT IS “SMART”

Figure 2.2 shows that over 50 percent of the wealth of the world wasin real estate in 2000. In the United States, real estate accounted for48.2 percent of the wealth (of which residential real estate repre-sented 36.7 percent). Equity investments (stocks) amounted to 19.3percent and bonds 21.1 percent.

REAL ESTATE VERSUS ALL OTHER REAL ESTATE INVESTMENTS

In the past 20 years, residential income properties have delivered thehighest average total investment returns of all real estate types. With abuilt-in hedge against inflation, it ’s no wonder that multifamily real es-tate has out-performed all other types of real estate investments with

REAL ESTATE VERSUS ALL OTHER INVESTMENTS 11

relatively low risk. Based on supply and demand over the next 10 years,residential income will out pace all other types of real estate invest-ment. Strong demographic and financial indicators along with chang-ing lifestyles should continue to positively influence residential incomeinvestments.

With an average unleveraged rate of return of 10.2 percent over thepast 20 years, residential income property has proven to be an attractivelow-risk investment. Figure 2.3 shows that from 1990 to 2000 residentialincome investment provided a more consistent higher total average rateof return than all types of properties and with less variance.

Although 10.2 percent is a great rate of return, it won’t get me on thedance floor. What will get me dancing is the rate of return using lever-age. A rate based on a 25 percent down payment works out to be almost24 percent. This type of return definitely gets my feet moving.

Appreciation MonthsRate Double Quadruple

LEVERAGE = 10�15% 23 648% 15 40

12% 10 2715% 8 2220% 6 16

LEVERAGE = 5�15% 44 1138% 28 71

12% 19 4815% 15 3820% 11 29

LEVERAGE = 3�165% 70 167

8% 44 10512% 29 7015% 24 5620% 18 42

Leverage = 1�15% 167 3348% 105 209

12% 70 14015% 56 11220% 42 84

Figure 2.1 Number of months to double and quadruple your money atselected interest rates. Source: The Center for Real Estate Studies.


Three Advantages Apartments Have over Other Types of Real Estate

Apartments should remain well ahead of other major property typesbecause they are generally more stable. Three important factors ac-count for this stability:

1. They are less dependent on business cycles for occupancy thanany other types of real estate investments. It doesn’t matter if in-terest rates and home prices are high or low, apartments are gen-erally more affordable.

Figure 2.2 Wealth of the world 2000 and wealth of the United States 2000.Source: The Center for Real Estate Studies.

Precious Metals3.0% Cash

3.2%

Stocks17.5%

Bonds20.1%

Real Estate56.2%

World

Real Estate48.2%

Bonds21.1%

Precious Metals4.9%

Cash6.5%

Stocks19.3%

United States

REAL ESTATE VERSUS ALL OTHER INVESTMENTS 13

2. Apartments have shorter leases; thereby offering greater protec-tion from inflation than the long-term leases associated withother properties. That is, rents can be negotiated more frequently.

3. The pool of tenants is much greater for apartments than othertypes of properties. This ensures a more consistent occupancythan industrial and commercial properties, which usually haveonly a few tenants to choose from.

The Building Size That Gives You the GreatestProfit Potential

When investing in apartment complexes, try to find the right buildingsize that makes the best use of your time and gives you the greatestprofit potential. Single-family houses and small apartment units do notalways work because of the competition and property managementproblems. Managing property on a day-to-day basis may not be for you.You could spend just as much time on a four-unit building as on a 40-unit complex and not make nearly as much money. In fact, because own-ers of smaller properties usually become emotionally attached to theirproperty, you tend to spend more time with them telling them that theymade the right move. Larger units are the domain of the institutional

Figure 2.3 Property sector performance 1990–2000. Source: National Councilof Real Estate Investment Fiduciaries.

Ind

ex

Year

300

250

100

50

200

150

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Multifamily All properties


investors, and you can’t compete with their availability of funds. Aftermaking many property transactions, you may find, as we did, that mid-size apartment buildings are the right niche.

APARTMENTS—THE COMING BONANZA FOR YOU

Supply and demand play an important role in residential income prop-erty value. The demand for rental property is increasing because thenumber of people entering the rental market is increasing steadily eachyear. At the same time, construction costs, stricter zoning ordinances,and environmental factors are limiting the new construction of resi-dential income property. Together, these trends bode well for investingin residential income property.

The greatest demand for rental property is being created by the BabyBoomers’ children, called Echo Boomers. An analysis from the book byHarry Dent, The Roaring Twenties, shows the increasing apartment de-mand created by Echo Boomers. His cycle is calculated by lagging thebirth rate by 25.5 years (Figure 2.4). It shows that the Echo Boomers,who traditionally make up a significant percent of the adult population,are moving more rapidly into the rental market (Figures 2.5 and 2.6). Inaddition, lifestyle changes and elderly preferences are swelling theranks of renters.

Figure 2.4 The apartment rental cycle for Baby Boomers and Echo BabyBoomers who will typically need these properties between the ages of 16and 251⁄2.

1982

5,500

5,000

4,500

Tho

usan

ds

4,000

3,5001988 1994 2000

Year2006 2012 2018

15

Figure 2.5 Growth in the Echo Boom generation. (Annual change inindividuals 20 to 34 years old.)

1997 2000

–2.0

2001

0.0

2002Year

0.4

2005

1.0

2010

5.6

–10

–8

–6

–4

–2

0

Perc

ent

2

4

6

8

–8.4

Figure 2.6 Echo Boom population in thousands.

Year

61,000

60,000

56,000

55,000

59,000

58,000

57,000

1997 2000 2001 2002 2005 2010


Because the 1997 tax act allows joint owners to exempt capital gainsof $500,000, more and more people are selling their homes, saving theirmoney, and moving into rental property. It is estimated that the de-mand for rentals is likely to increase over 10 percent during the next 10years. Residential income property offers one of the best protectionsagainst inflation. In fact, a study reported by the Journal of Financial Eco-nomics found that residential real estate is the only investment that of-fers a complete hedge against both anticipated and unanticipatedinflation.

People always need the three basics—food, clothing, and shelter. Asthe population grows, the need for shelter grows along with it. Thehedge against inflation with residential rentals is greater because, un-like long-term commercial leases, they are generally on a month-to-month basis. As prices increase, apartment owners can increase rentsmore rapidly with month-to-month leases than commercial owners whohave long-term leases.

Low-rise developments or garden apartments in suburban communi-ties account for more of the buying and selling transactions than luxuryapartments (which have a much smaller market). Remember what wesaid in Chapter 1—7 out of 10 millionaires made their money in realestate. Shelter is not only vital, but it ’s often the greatest part of a per-son’s net worth.

Residential income property is one type of investment that is a sourceof security and stability. Every investment has peaks and valleys, in-cluding rental real estate. But over the long-term, it always comes out ontop. The key is knowing the right time to buy and sell. That is the goldenrule in investing. This book will give you the knowledge you need to in-vest at the right time and right place.

Table 2.1 Real estate as a portfolio shock absorber 1979–2001.

United States 1979–2001

S&P Russell Lehman500 2000 Corp. Bond

Number of times quarterly return is less than −2.5% 16 25 8

Number of times real estate return has been positive in:Same period 15 24 8Lagged 1 period 14 23 8Lagged 2 periods 14 23 8Lagged 3 periods 12 22 8Lagged 4 periods 13 20 8

Source: LaSalle Investment Management.

SUMMARY 17

REAL ESTATE: THE SHOCK ABSORBER

Real estate generally outperforms equities because of its higher yields,greater price stability, and downside protection even in a recession.Table 2.1 shows how many times over the past 20 years real estate hasplayed such a role for investors. When stock markets are down, real es-tate holds value and produces a positive return. Real estate is less proneto booms and busts than in the past. Residential income-producing realestate is now stronger than it has been in many years.

SUMMARY

Since apartments can be seen and touched—and are not an abstract formof ownership evidenced by a piece of paper—they are investor friendly.People can identify with doors and windows, bedrooms and bathrooms,and floors and roofs. They don’t feel that the market is being manipu-lated by programmed buying and selling. They feel they have controlover their investments.

Shelter is one of the basic necessities of life. You can’t comfortablysleep on gold, silver, or stock certificates, but you can stay warm and drywith a roof over your head. There will always be a need for housing. Andmidsized apartments fit the bill.

19

3The New Approach to Investing in the21st Century

FORECLOSURES—THE BIG ILLUSION

Periodically, governmental agencies advertise real estate foreclosureauctions that result from various liens (real estate taxes, IRS audits,and criminal attachments, for example). Let me tell you about my ex-periences with one of these foreclosure auctions.

It all began when I called a telephone number in an advertisement,and requested a list of the properties to be auctioned. The agency han-dling the sale recommended that I inspect the properties before at-tending. There were at least 500 properties listed. I only found 10 thateven came close to fitting my standards for investment-grade rentals.Most of the properties were single-family residences. There were nomidsize apartment buildings, so I had to settle for smaller units.

For six weeks before the auction, I attempted to inspect the proper-ties I’d selected. This proved very difficult. Most of the time I had toreturn a second or a third time to look inside the building. I was unableto inspect all 10 units.

c03.qxd 4/5/04 11:34 AM Page 19

20 THE NEW APPROACH TO INVESTING

In attempting to complete my homework, I was able to obtain compa-rable sales information on most of the buildings. No money was spent tosecure independent appraisals. With my real estate background, I feltcapable of determining market values. I did incur some costs by havinga contractor inspect a few buildings, however. Determining the cost ofrepairs necessary to collect market rents would be important in decid-ing how much to bid at the auction.

When trying to secure loans, I found many lenders were not inter-ested in these kinds of properties. Those that were interested, wantedhuge down payments, some as high as 50 percent. One lender wanted tocross-collateralize my other properties as additional security to makethe loan. Because obtaining the loan was becoming a problem, I turnedto the agency conducting the auction; perhaps they would assist in thefinancing.

I reviewed all the paperwork several times to make sure I had not for-gotten anything, and the day before the auction I was confident every-thing was in order. I had spent much time and some money to make suremy figures were correct. I was ready for the big day. I thought I was onmy way to becoming a millionaire. I wasn’t thinking about all the effortI had spent just to be able to make a bid at the auction. My thoughts wereon the millions of dollars I was going to make. At the time, if I hadknown what my chances were of actually purchasing any of the build-ings, I wouldn’t have wasted my time or money. Unfortunately, the onlything I saw was unbridled opportunity. I was blinded by my hopes andambitions to the realities of the situation.

The auction was held at a convention center in an enormous buildingthat was capable of holding at least 50,000 people. I arrived at 7:30 in themorning, hoping to gain the early bird advantage. There were at least2,500 people ahead of me. I had to pay a fee just to enter, then a 50-pagebrochure describing all the properties was handed to me.

I began orienting myself as to the layout of various booths and sched-uled activities. The crowd, which was milling around, got larger andlarger as the morning wore on. I was able to locate the booths where theproperties on my list were to be auctioned. While making note of auc-tion times in my brochure, an auctioneer handed me a piece of paper. Itscontents nearly bowled me over. The heading read “PROPERTIES TO BEDELETED FROM AUCTION.” At first, it appeared that all the proper-ties were deleted because the list was so long. Approximately 400 wereremoved, and that meant only about 100 were left. I looked at all the peo-ple scurrying around at the auction, and I was devastated. In an effort totry to salvage my dream of becoming a millionaire, I began to check theproperties on my list against the ones that were deleted. After several

c03.qxd 4/5/04 11:34 AM Page 20

FORECLOSURES—THE BIG ILLUSION 21

anxious moments, I was able to find two properties that weren’t on thedeletion list. I didn’t know whether to laugh or cry. “Well,” I thought,“since I’m down here anyway, I’ll just stay for the two. At least it won’tbe a complete waste of time.”

I spent the rest of the afternoon attending both auctions, and I didn’tget either property. They were sold for prices far beyond what I had cal-culated as being reasonable. There were too many people bidding, andcrowd emotions rather than reasoning prevailed.

What They Don’t Tell You about Foreclosures

What happened? Why were so many properties deleted from the list?I later discovered many owners either reinstated their loans or initi-ated legal proceedings to stop the sale. In checking further, it becameapparent that in most auctions, the better properties end up thisway—they never get to the sale. The properties that finally do get auc-tioned have justifiable reasons for ending up on the auction block.Most either have significant physical problems, or they don’t makesense economically. By trying to invest in these kinds of properties, Iwould be throwing my money out the window. In fact, according toDaniel Furniss, an attorney who filed a class-action suit involvingprice-fixing in foreclosures, 85 percent of home foreclosures in thestate of California end in redemption rather than sales. According tofigures published by Experian Real Estate Information Services, thefive counties in California with the highest number of Notices of De-fault (Los Angeles, San Diego, Riverside, Orange, and Santa Clara)had only 12 percent of the properties go on sale. With so many peopletrying to buy so few foreclosures, it became apparent that this giganticillusion was not for me.

Foreclosure “experts” suggested that I try buying preforeclosureproperties by contacting owners in distress. Contacting apartment in-vestors didn’t bother me—they had invested knowing the risks. Butcontacting someone whose home was about to be taken away was a dif-ferent story. I know the anguish that I would feel if someone was tryingto take away my home. I just couldn’t do it! I believe that, in life, peoplewho continually try to become rich on other people’s personal miseryend up miserable themselves.

Someone tried to convince me that if I got to the owner before the sale,both of us would benefit. I wanted to verify this. After talking with pro-fessionals in the field, I discovered that preforeclosure properties couldhave undisclosed contingent liabilities. That is why financial institu-tions, in order to clear title, take back properties through foreclosure

c03.qxd 4/5/04 11:34 AM Page 21


proceedings rather than buying them directly from the owner beforethe sale. Even with title insurance, the financial institutions want thisadditional protection. I felt the same. Not only would I be buying theproperty, it was possible I could also be buying someone else’s prob-lems, and clear title might be obstructed. It was possible that I couldend up losing the property to creditors or spend time in court fightingcountless legal battles.

In addition, many states have consumer protection laws dealingwith foreclosures. Failure to comply with these laws will get you into agreat deal of trouble.

WHY APARTMENTS ARE THE BEST INVESTMENT

Basic reasons why midsize apartment buildings make the best invest-ments include:

1. Competition: Usually there are fewer qualified buyers for mid-sized or larger apartments than there are apartments available.Result: You have a few people chasing very good opportunities.

2. Limitations: Because of the economy of scale approach, there arefewer limitations as far as location is concerned in buying rentalproperty. You can buy anywhere these pockets of opportunityexist because of the economy of scale.

3. Frequency: You do not have to do as many transactions becauseyou’re dealing with larger properties, therefore, reducing yourchances of making the wrong decisions. You have more time toanalyze each deal to make the best decisions.

Working Smarter Not Harder

Some people believe constant movement equates to productivity. Theybelieve, if they work harder than the next guy, they’ll succeed. Hardwork is important, but working smarter is better. The smarter you work,the greater likelihood you’ll succeed.

Instead of spending countless hours driving around areas withinyour city looking for good buys, spend a fraction of the time findinggood locations in other cities, states, or countries by using the simpletechniques introduced in this book.

How many times have you heard, “I don’t get involved in the bigdeals. They are out of my ballpark.” These people have been afflictedwith the disease that I call “smallitis.” Just because they have fewer

c03.qxd 4/5/04 11:34 AM Page 22

GROUP INVESTING 23

investment dollars than the big guys, they feel they have to settle forsmaller properties. If they only knew that with as little as $6,000, theycould be three deals away from being a millionaire, I wonder whatthey would do. What would you do? Would you take the cure or not?

If you want to become successful, don’t follow the crowd. Don’t scurryaround continually chasing financial fads. Eventually you will becomeweary and give up. You must force yourself to sit down and analyzeyour moves. If you have smallitis, this book will cure it. I will show youhow to become financially healthy taking just a few doses of the mira-cle remedy.

BECOME A MILLIONAIRE IN ONLY THREE MOVES

You can become a millionaire starting with just $6,000, and you can doit in only three moves: Start by researching midsize apartment build-ings. By midsize apartment buildings, I am referring to the number ofunits in a complex, not the height or square footage. Typically, a mid-size apartment building has anywhere from 18 to 100 units.

You’ve heard the old saying, “It takes money to make money.” Be-lieve me, it ’s true. Money working for you can earn more than youworking for money. Ask yourself, would 10 years of paychecks turnyou into a millionaire? Investing wisely could! You need to invest insomething that is going to yield the rate of return that’s required to be-come rich. That something is rental real estate, and apartment build-ings give you the best opportunity with the lowest possible risks.

The problem most people have with investing in rental real estate isthat they don’t have enough money to buy midsize apartment build-ings on their own. Consequently, many end up buying single-familyresidences or smaller properties. While these sometimes can be goodinvestments, many more moves are required to be successful, thus in-creasing the risks and chances of failure.

Some real estate investors try to circumvent their lack of money byattempting to buy smaller properties using the tactics preached bysome “no-money-down gurus” at their seminars. Innocent people havefallen prey to these charlatans, and they have ended up not only losingmoney, but also, and most importantly, their own self-confidence.

GROUP INVESTING

There is a better way to invest when you have limited funds. You shouldcombine your investment dollars with others to form an investment

c03.qxd 4/5/04 11:34 AM Page 23


pool to purchase midsize apartment buildings. Chapter 13 shows youthe easy-to-learn techniques of creating such an investment pool. Thisapproach protects each individual’s interest and creates many new taxbenefits. The concept of pooling money is known as group investing.

Group investing allows you to gather adequate funds to purchase amidsize apartment building. Midsize buildings make economic sensebecause of the concept of “economies of scale.” The cost per square footof investing in and operating midsize apartment buildings is typicallymuch less than smaller buildings. For example, assume you wantedyour fourplex painted. The painter is going to quote you a much highersquare foot price for the 4-unit building than if you asked for a quoteon a 40-unit building.

The same holds true with vacancies. If one unit is vacant in a four-plex, there is a 25 percent vacancy factor. In a 40-unit building, one va-cancy is only 2.5 percent. Units in midsize buildings tend to rent formore than those in smaller complexes because they typically have moreamenities, such as swimming pools, landscaping, and recreation andlaundry facilities, for example.

Midsize buildings are also less management intensive than smallerones. The cost of hiring a property manager for many single-family res-idences is more than any cash flow it may generate. Even in a duplex ora fourplex, the costs are usually high. Managing the property yourselfis not the answer. You’ll quickly find out how much of your own labor isinvolved in keeping the complex running. Giving a tenant a small breakon the rent to act as a manager can open you to potential liability.

Most part-time resident managers have little or no experience man-aging property, and they lack the knowledge of the legalities involved.They may learn from their mistakes, but it could be very costly to you.A midsize apartment building purchased correctly has sufficientrental income to support an expert property management company.Their expertise will make your property run at its best. Chapter 10covers what you need to know to direct your property managementcompany to be sure it is doing a good job. You’ll find it’s a lot less workmanaging a property management company than it is managing yourproperty.

The number one question for you to consider is where to buy yourproperty. There are many apartment buildings in the world. You need tofind a location that has the greatest potential for appreciation, becausethat’s where the real money is. Try to find areas that are currently eco-nomically depressed, and that are projected to begin recovering. Buy amidsize apartment building in this type of market and you’re on yourway to becoming wealthy. How do you find these kinds of locations?

c03.qxd 4/5/04 11:34 AM Page 24

GROUP INVESTING 25

Step 1: Research

The first part of becoming a real estate millionaire is research. Chapter 5describes how to perform the kind of research needed. The goal of thisresearch is to determine future values in various real estate markets.

In 1981, my investment group made its first move at the culminationof a tremendous amount of research. In the beginning, the bulk of myresearch centered around finding the right clues needed to evaluatevarious markets. Thirteen different variables in over 200 MetropolitanStatistical Areas (MSAs) were tracked for 15 years by my real estate re-search department. We discovered that vacancy rate movements werethe best indicators of the health and potential profitability of the mar-ket. In addition, vacancy rate trends were found to predict futurerental rates. Since apartment building values are heavily influenced byrental rates, having an accurate prediction of future rental rates gaveadvanced notice of potential price changes. This meant that we had thecapability of making moves before others.

We further analyzed the effects that various combinations of datahad on changes in vacancy rates, and meaningful prediction equationsbegan to emerge. If we could successfully predict changes in vacancyrates, we could then predict future rental rates. Once we predicted fu-ture rental rates, we had a handle on future apartment prices. Havingthis much lead time in the apartment market would give us the oppor-tunity to jump into a market just before it turned hot (before the rushof other investors) to gain the greatest economic benefit. It would alsoallow us to leave a market before it turned cold.

There were a number of areas that exhibited predicted favorablechanges in vacancy rates. An area that showed a great deal of promisewas Phoenix, Arizona. Our equations predicted a 29.3 percent drop inthe vacancy rate would occur in 1982. In addition, building permits forthis area had peaked at 11,421 in 1979 and were starting to decline, sug-gesting that an overbuilding situation was ending. With these factors inmind, we decided to look in Phoenix for a midsize apartment buildingto purchase as our first move.

To analyze the property, we had to find out what type of financingwas available. Based on data from comparable sales in the area, we wereable to determine the availability of various financing packages. Sinceseller financing was feasible, we opted to use it in our analysis. Usingseller financing produced more leverage, an increased cash flow, andgreater tax benefits.

The purchase of a hypothetical apartment building for $600,000 onJanuary 1, 1981, was our first model. Our group had 10 investors, each

c03.qxd 4/5/04 11:34 AM Page 25


contributing $6,000. The $60,000 pool was then used as a 10 percentdown payment on the property.

The purchase price of $600,000 was determined by dividing the totalamount of money pooled by 10 percent, the amount of the down pay-ment ($60,000/10%). Total building square feet of 20,000 was calculatedby dividing the purchase price of $600,000 by the acquisition price persquare foot of $30 (provided by Commercial Leasing Update in Volume V,No. 2 [February 1990] by Kammrath & Associates).

The total number of units in the complex was based on comparablesales data of $23,000 per unit for a total of 26 units. To achieve maxi-mum rental income, it is important to have the correct type of units(called the unit mix). The most desirable unit mix for this area was twoto one. In other words, for every one-bedroom unit there should be atleast two two-bedroom units. Preferably, the average one-bedroom unitshould be 650 square feet and the two-bedroom units should be 825square feet. Our sample building contained 18 two-bedroom units and8 one-bedroom units.

The financial aspects of the acquisition were as follows:

Purchase price $600,000

First mortgage 420,000Second mortgage 120,000Down payment 60,000

Total purchase price $600,000

With 70 percent of the purchase price covered by the first trust deedand 20 percent by seller financing, only 10 percent down was required topurchase the property. The first mortgage was at 11 percent amortizedover 30 years with payments of $4,000 per month. The seller financingavailable for the second mortgage was structured differently. For thefirst two years, the seller accrued all interest at 10 percent due at matu-rity. This interest did not compound. For the next two years, the selleraccrued 5 percent interest and was paid 5 percent interest ($500) permonth. The accrued interest was due at maturity, and it did not com-pound. For the final two years, the seller was paid interest at 10 percent($1,000 per month) with no accrual. At the end of the sixth year, theprincipal balance and accrued interest were due and payable.

Operating income and expense per square foot were compared tothose published by both local real estate associations and the Insti-tute of Real Estate Management (IREM). Local property managementfirms were consulted to evaluate operating conditions, assist in the

c03.qxd 4/5/04 11:34 AM Page 26

GROUP INVESTING 27

estimates, and verify ratios. Based on our findings, the following netcash flow projections were made:

First year $21,375Second year 22,377Third year 13,479Fourth year 14,274Fifth year 12,776

Total cash f low $84,281

After three years, it was anticipated that the initial cash outlay wouldbe repaid. In addition, the projected cash generated from operationswould be entirely tax free for the first two years. For years three throughfive, only $1,000 to $2,000 of the cash flow would be taxable—a verysmall amount indeed.

Since the average rental rate for a unit was $327 a month, our annualrental rate for all 26 units was $102,024.

Per IREM’s reports, projected annual operating expenses of 35 per-cent on this project were broken down as follows:

Administrative expenses (6.9%) $ 7,050Operating expenses (9.2%) 9,400Maintenance expenses (7.2%) 7,350Taxes/Insurance (8.3%) 8,450Recreational/Amenities (.2%) 200Other payroll (3.2%) 3,250

Total annual expenses $35,700

Using a computer program developed by The Center for Real EstateStudies, we monitored the local market conditions on a quarterly basis.At the same time, we monitored other areas in case other investmentopportunities became available.

In 1982, the Phoenix vacancy rate dropped by 30.6 percent; out-standingly close to our projection of 29.3 percent. Using the 1982 data,we expected to see another 5 percent decrease in the vacancy rate in1983. Actual data from 1983 shows that there was no change in the va-cancy rate between 1982 and 1983. The expected decrease in vacancyrates did not occur because of an unexpected doubling of the numberof building permits issued in 1983. These extra units started to come online toward the end of the year and prevented a further decrease in thevacancy rates. Rental rates for the area continued to rise during the

c03.qxd 4/5/04 11:34 AM Page 27


year to 4 percent, which was an improvement over the prior year. Ourestimates for 1984 predicted a rise in the vacancy rate of 31 percent. Atfirst glance, our inclination was to sell the property as soon as possible.However, further analysis told us to take a wait-and-see approach.

Building permits and rents were expected to continue to increasedespite the rise in vacancy rates. We decided to hold on to the propertyfor one more year to make sure we did not sell too soon. In 1984, theactual vacancy rate only went up 23.8 percent. While quite high, itwas not as bad as we had feared. Property values increased 10.3 per-cent. Apparently, we had made the right choice not to sell. It was pre-dicted that 1985 was to have another increase in the vacancy rate, butthis time it was accompanied by a drop in building permits (indicatingthe beginning of a slide in the market), and a decrease in rents (also abad sign for an area). Based on these predictions, we decided it wastime to move from Phoenix to a better market.

Current sales conditions in Phoenix were still good based on salesactivity. There appeared to be a number of serious buyers on the mar-ket, and although prices had leveled off, they had not yet started to slip.Scrutinizing comparable sales data confirmed financing was not a prob-lem. We were selling at the right time in the apartment cycle.

A selling price of $860,000 was calculated by multiplying the totalsquare footage by the selling price per square foot of $43, as providedby the National Real Estate Index.* Total cash flow from the operationsof the property combined with the equity from the sale yielded a totalof $354,650, as of December 31, 1985. Each of the 10 investors in ourpool netted $35,465 on their $6,000 investment. This represents an an-nual rate of return of nearly 100 percent for each of the five years theproperty was owned (see Figure 3.1).

Step 2: Decreasing the Group Size

The time was ripe to make the second move on our quest to become mil-lionaires. The proceeds from the first sale were traded, without payingtaxes, to another property. By keeping up with the research, we knewexactly where to purchase the next apartment building.

Since we did so well on our first move, we were able to make the sec-ond move with a smaller group of investors. From the very beginning,

*The National Real Estate Index (Liquidity Fund, Emeryville, CA) reported only averageapartment prices for Class A garden-style complexes. Within any given city, there aremany locations and different classes of apartment buildings that provide even greateropportunities to improve on this rate of return.

c03.qxd 4/5/04 11:34 AM Page 28

GROUP INVESTING 29

the ultimate goal was to end up as sole owner of a very profitable mid-size apartment building.

Our second move involved a property that would require a $175,000down payment. Consequently, we needed only half of the originalgroup to reinvest in the second property since each of the original in-vestors now had $35,465 instead of the original $6,000. So, with a groupof five members we made our second move.

In making the second move, we discovered that Boston, Massachu-setts, had the profit potential we were looking for. Our equations pre-dicted a 7.6 percent rise in the vacancy rate in 1986. This is usually anindication of a softening market, but market conditions indicated other-wise. In 1985, there was a sudden jump of 9,653 building permits—al-most triple the number of permits from the year before. This was at leastdouble every other prior year’s building permits over the past six years.This sudden construction boom led to the increase in vacancy rate in

PhoenixPurchase of 26 Units

Purchase price (1/1/81) $ 600,000.00Loan proceeds −540,000.00

Net cash outlay $ 60,000.00

Sale of PropertySelling price (12/31/85) $ 860,000.00Closing costs −25,800.00Pay off balance of loans −563,832.75

Cash received before taxes (tax-deferred exchange) $ 270,367.25

Net Operating Debt Net CashDate Income Service Taxes Flow

Year 1 $66,900.82 $47,997.00 $ 2,471.38 $ 21,375.20Year 2 68,177.65 47,977.00 2,197.24 22,377.89Year 3 69,454.55 53,997.00 −1,977.68 13,479.87Year 4 70,729.53 53,997.00 −2,458.11 14,274.42Year 5 72,000.44 59,997.00 772.85 12,776.29

Total cash flowfrom property $354,650.92

Figure 3.1 Phoenix purchase of property. Data Sources: The Center for RealEstate Studies; Residential Property Analysis; square foot data from NationalReal Estate Index, published by Liquidity Fund, Emeryville, CA (800-992-7257);per unit sales data from Kammrath & Associates, Commercial Leasing Update,February 1990.

c03.qxd 4/5/04 11:34 AM Page 29


the following year, but it was not projected to continue. Future buildingpermits were expected to drop off over the next few years. In addition,other factors indicated that the demand for apartments would be in-creasing at an above-normal rate for the next two years. Without a hugeinventory of new units coming on line, the increased demand was pro-jected to force the vacancy rate down.

One of the factors indicating an increased demand for apartmentunits was the median home price. The median home price had jumped al-most 35 percent in 1985. Compare this to a household income that hadbarely changed during the same period. Without a higher income,many people who would normally have purchased a home were forcedto stay in apartments. By not leaving the market as they had done inthe past, the demand for apartments was anticipated to increase. Em-ployment and the number of households were projected to continue togrow as well. All these factors indicated that the increase in the va-cancy rate would be temporary.

As with the Phoenix area, market conditions indicated that seller fi-nancing was available in Boston. There were many different types of fi-nancing packages to choose from, but our cost analysis pointed us toseller financing. In fact, seller financing is usually the most economicalmethod to use.

The availability or lack of seller financing also gives additional cluesas to current market conditions. While seller financing indicates a“soft” real estate market where buyers can make good deals, the lack ofseller financing indicates a “hot” market. Since a hot market is one thatfavors the seller, it usually means that the seller can maximize profits.A hot market is a good time to sell real estate, but not a good time to buy.

Our second hypothetical apartment building was purchased inBoston, Massachusetts, on January 1, 1986. Our group had five investors,each contributing $35,000. The $175,000 pool was then used as a 10 per-cent down payment on the property. The selling price of $1,750,000 wasreached by dividing the money pooled ($175,000) by the 10 percent downpayment.

Total building square footage of 32,258 was calculated by dividingthe purchase price of $1,750,000 by the acquisition price per square footof $54.25, as published by the National Real Estate Index.

The total number of units in the complex was based on the totalsquare footage and the unit mix to yield 44 units. The most desirableunit mix for this area was three to one. In other words, for every one-bedroom unit there should be at least 3 two-bedroom units. Preferably,the average one-bedroom unit should contain 600 square feet, and the

c03.qxd 4/5/04 11:34 AM Page 30

GROUP INVESTING 31

average two-bedroom unit should contain 775 square feet. Our samplebuilding included 33 two-bedroom units and 11 one-bedroom units.


Purchase price $1,750,000

First mortgage 1,225,000Second mortgage 350,000Down payment 175,000

Total purchase price $1,750,000

The first trust deed was 70 percent of the purchase price. Seller fi-nancing amounted to 20 percent; therefore, only a 10 percent down pay-ment was required.

The first mortgage was at 11 percent amortized over 30 years withpayment of $11,665.91 per month. The seller financing available for thesecond mortgage was structured as follows: for the first two years, theseller accrued all interest at 10 percent due at maturity. This interestdid not compound. For the next two years, the seller accrued 5 percentinterest and was paid 5 percent interest ($1,458.33 per month). Againthe accrued interest was due at maturity and did not compound. Forthe final two years, the seller was paid interest at 10 percent ($2,916.66per month) with no accrual. At the end of the sixth year, the principalbalance and accrued interest were due and payable.

Operating income and expenses per square foot were compared tothose published by both local real estate associations and IREM. Localproperty management firms were consulted to evaluate operating con-ditions, assist in the estimates, and verify ratios. Based on our find-ings, the following net cash flow projections were made:

First year $50,632Second year 67,483


By the time the property was sold, over $100,000 of the initial cashoutlay had been repaid, and it was entirely tax free.

Gross annual rental income was derived by multiplying the averagerental rate of $8.01 per square foot times the total square footage of32,258 square feet, for a total of $258,387. Per IREM’s reports, projectedannual expenses of 35 percent of gross income were broken down asfollows:

c03.qxd 4/5/04 11:34 AM Page 31


Administrative expenses (7.4%) $19,120Operating expenses (8.6%) 22,220Maintenance expenses (5.4%) 13,953Taxes/Insurance (9.7%) 25,064Recreational/Amenities (.4%) 1,034Other payroll (3.5%) 9,044


Working with the same computer program, we continued to monitorlocal market conditions on a quarterly basis to keep abreast of changesthat could affect our investment and to be aware of other investmentopportunities as they became available.

In 1986, the Boston vacancy rate rose by 13.2 percent. Using the new1986 data, we expected to see a 12.1 percent decrease in the vacancyrate in 1987. We were not overly concerned with the vacancy rate sincethe average rental increase was 9.9 percent in 1986. We reasoned thatwith a decrease in the vacancy rate, the rental rates would increaseeven more. Actual data from 1987 shows that there was only a 7 percentdecrease in the vacancy rate, but once again the rental rates had in-creased, this time at an average of 9.4 percent for 1987. Our estimatesfor 1988 predicted a rise in the vacancy rate of 10 percent. When thesecond rise in the vacancy rate occurred, we started to make plans tosell. Our research had shown us that the Seattle, Washington, area wasdeveloping extraordinary potential.

Boston’s median home price was predicted to level off in 1988, andhousehold income was expected to rise—an indication of a renter exo-dus into single-family houses in the near future. There were no otherindications that this loss in demand would be offset by any other fac-tors. Unfortunately, the potential increase in the vacancy rate was real.We decided to leave the uncertainty in the Boston market for thegreater potential in Seattle.

Sales conditions in Boston were very good. The recent drop in thevacancy rate drew many sellers back into the Boston market. It was def-initely the right time to sell.

A selling price of $2,325,000 was calculated by multiplying the totalsquare footage of the property (32,258) by the selling price per squarefoot of $72.13, as listed in the National Real Estate Index for Boston. Totalcash flow from the operations of the property combined with the eq-uity from the sale yielded a total of $740,574 as of December 31, 1987.Since there were now only five investors in our pool, each investor net-ted $148,115 for each $35,000 invested. This represents a return of over323 percent, or approximately 162 percent per year (see Figure 3.2).

c03.qxd 4/5/04 11:34 AM Page 32

GROUP INVESTING 33

At the end of the second move, some people might be tempted tostop here, count their winnings, and leave the real estate game. Forthose of you who wish to make the last move and gain real financial in-dependence, please follow along.

Now it is time for the third move to make $1 million. The proceedsfrom the second sale were reinvested, through the use of a tax-deferredexchange, into another property. Relying on our research, we knew ex-actly where to buy the next apartment building. The $145,000 receivedfrom the sale of the second property was used for the purchase.

The acquisition price was calculated by dividing the $145,000 by a 10percent down payment, or $1,450,000 ($145,000/10%). Total buildingsquare feet of 30,039 were determined by dividing the purchase price of$1,450,000 by the acquisition price per square foot of $48.27 as providedby the National Real Estate Index.

The total number of units in the complex was based on the totalsquare footage and the unit mix to yield 40 units. The most desirableunit mix for the Seattle area was three to one. Again, for every one-bedroom unit there should be at least three two-bedroom units.Preferably, the average one-bedroom unit should contain 600 square

BostonPurchase of 40 Units

Purchase price (1/1/86) $ 1,750,000.00Loan proceeds −1,575,000.00


Sale of PropertySelling price (12/31/87) $ 2,325,000.00Closing costs −69,750.00Pay off balance of loans −1,632,790.38



Year 1 $178,153.67 $139,992.00 $12,470.05 $ 50,632.19Year 2 202,060.83 139,992.00 5,413.74 67,483.04

Total cash flowfrom property $740,574.85

Figure 3.2 Boston purchase of property. Data Sources: The Center for RealEstate Studies; Residential Property Analysis; square foot data from NationalReal Estate Index, published by Liquidity Fund, Emeryville, CA (800-992-7257).

c03.qxd 4/5/04 11:34 AM Page 33


feet and the average two-bedroom unit should contain 800 squarefeet. My sample building contained 30 two-bedroom units and 10one-bedroom units.


Purchase price $1,450,000

First mortgage 1,015,000Second mortgage 290,000Down payment 145,000

Total purchase price $1,450,000

The first mortgage was 11 percent amortized over 30 years with pay-ment of $9,666.08 per month. Seller financing for the second mortgagewas structured as follows: for the first two years, the seller accrued allinterest at 10 percent, due and payable at maturity. Interest did not com-pound. For the next two years, the seller accrued 5 percent interest andwas paid 5 percent interest ($1,208.33 per month). Again the accrued in-terest was due at maturity and did not compound. For the final twoyears, the seller was paid interest at 10 percent ($2,416.66 per month)with no accrual. At the end of the sixth year, the principal balance andaccrued interest were due.

Operating income and expenses per square foot were compared tothose published by both local real estate associations and IREM. Localproperty management firms were consulted to evaluate operating con-ditions, assist in the estimates, and verify ratios. Based on the find-ings, the following net cash flow projections were made:

First year $59,526Second year 64,777Third year 46,304


By the end of three years, the initial cash down payment had beenrepaid. The projected cash generated from operations for the first twoyears was entirely tax free and only 20 percent of the cash from opera-tions in the third year would be taxable.

The projected annual rental income of $261,340 was derived by mul-tiplying the average rental rate of $8.70 per square foot by the totalrentable square feet of 30,039.

Per IREM’s reports, projected annual expenses of 35 percent of grossincome were broken down as follows:

c03.qxd 4/5/04 11:34 AM Page 34

GROUP INVESTING 35

Administrative expenses (8.8%) $22,998Operating expenses (8.1%) 21,169Maintenance expenses (4.8%) 12,544Taxes/Insurance (8.7%) 22,737Recreational/Amenities (.3%) 784Other payroll (4.3%) 11,238


By using the computer program, we were able to monitor the localmarket conditions on a quarterly basis while still keeping track of thepockets of opportunity as they became available.

Step 3: Sole Investor

For the third move, I predicted that Seattle, Washington, had the great-est potential in 1988. The econometric computer model forecasted a 13.5percent drop in the vacancy rate in 1988. This drop was anticipated eventhough building permits were projected to increase from the 8,000 to10,000 range to between 12,000 to 13,000. Actual figures for 1988 showthe vacancy rate dropped 12.8 percent, and the building permits jumpedto 11,939. While rents only went up 4 percent in 1988, selling prices ofcomparable buildings increased as well. My projections for 1989 calledfor a 26.3 percent increase in the vacancy rate, to about 5 percent. Al-though it was a major jump, the overall vacancy rate was still predictedto be quite low. My forecast was that property values would continue toincrease, as would rental rates. In 1989, rental rates jumped another 7.5percent and property value jumped 17 percent. Indications were that themarket was going to start slowing down and that it might be time tostart looking elsewhere. Predictions for 1990 estimated the vacancy rateclimbing to 43.2 percent despite heavy employment growth.

I decided to hold onto the property until the end of 1990, for severalreasons. The vacancy rate increases would not really impact the marketuntil the fourth quarter of 1990. Consequently, rental rates and prop-erty values would continue to increase until then. Additionally, mypredictions showed that I should be able to meet my target goal of $1million without making any additional moves. Actual figures for 1990proved me right. Though the vacancy jumped a whopping 52.6 percentin 1990, the property values did not level off until the end of the year.For the year, rents climbed only 1.3 percent, but property values in-creased 13.8 percent.

As of December 31, 1990, the selling price was calculated to be$2,267,043, that’s the total square feet of 30,039 times the selling price

c03.qxd 4/5/04 11:34 AM Page 35


per square foot of $75.47, as provided by the National Real Estate Index forthe Seattle area. Total cash flow from operations and equity totaled$1,007,995. Since I was the sole owner, it meant that my $145,000 invest-ment earned an annual return of 200 percent each year (see Figure 3.3).

I reached my goal. I had successfully turned a $6,000 investment into$1 million in only three moves. The entire process took just 10 years. Youtoo can do it using the exact same methods.

SUMMARY

Don’t be misled by the financial fads in foreclosure and distressedproperties. With the number of people looking for these kinds of in-vestments, it ’s nearly impossible to find anything worth buying. Thereis simply too much competition to make it profitable.

Don’t limit your investments to a short driving distance from yourhouse. Expand your choices of locations by purchasing in areas wherepockets of opportunity exist.

SeattlePurchase of 38 Units

Purchase price (1/1/88) $ 1,450,000.00Loan proceeds −1,305,000.00


Sale of PropertySelling price (12/31/90) $ 2,267,043.00Closing costs −68,011.29Pay off balance of loans −1,361,643.88



Year 1 $173,081.81 $115,993.00 $ 2,436.98 $ 59,525.83Year 2 180,266.63 115,993.00 503.76 64,777.41Year 3 187,744.09 130,493.00 −10,947.02 46,304.07

Total cash flowfrom property $1,007,995.12

Figure 3.3 Seattle purchase of property. Data Sources: The Center for RealEstate Studies; Residential Property Analysis; square foot data from NationalReal Estate Index, published by Liquidity Fund, Emeryville, CA (800-992-7257).

c03.qxd 4/5/04 11:34 AM Page 36

SUMMARY 37

Spend time on a few good properties to make you wealthy instead ofbuying and selling many single-family houses and smaller units. Hav-ing to continually make investment decisions on numerous smallerbuildings doesn’t leave you much time to spend on each one; thereby,increasing the probability of making errors.

Analytically proven methods of finding good locations gives youthe ability to concentrate your efforts. In so doing, the likelihood of be-coming really wealthy is enhanced.

Remember, all you need to do is to make the right moves. It has beendone before. It will continue to be done in the future. Are you the onewho will do it?

c03.qxd 4/5/04 11:34 AM Page 37

c03.qxd 4/5/04 11:34 AM Page 38

39

4How to EffectivelyEmploy Consultants

ADVANTAGES OF A TEAM APPROACH

By investing in midsize apartment buildings, you will be able to use theservices of many consultants economically. Relying on a qualified groupof specialists will give you the added advantage of a team approach. Whenbuying larger properties and using as much leverage as possible, you’llneed competent input from qualified professionals. At this level, youcan’t afford to “shoot from the hip.” There’s too much at stake.

Paraphrasing an old saying: If you act as your own attorney, youhave a fool for a client. This could also apply to the person who tries tobe his or her own property manager, real estate broker, accountant, es-crow officer, building inspector, loan broker, and/or appraiser. It takesmany skilled people to make a winning team. If you try to become pro-ficient in all of these areas, you will go through a very expensive learn-ing curve. More importantly, you will waste valuable time. Instead,spend your time and effort learning how to acquire and direct a teamof experts.

40 HOW TO EFFECTIVELY EMPLOY CONSULTANTS

PICKING THE RIGHT CONSULTANT

When choosing members for your team, be sure they are qualified tohandle matters pertaining to your investment. Search for profession-als who have education and experience in the real estate field, in gen-eral, and midsize apartment buildings, in particular. Don’t let aproperty management company that caters to single-family resi-dences manage your midsize apartment building. Don’t employ afamily law attorney to read rental contracts. Be sure you find theright consultant for each job.

Begin your search for real estate experts by asking for referrals fromlocal real estate-oriented banks in areas where you plan to invest. Banksfrequently use real estate consultants. Check with title companies andreal estate associations for additional names.

Professional designations such as CPA (Certified Public Accoun-tant), CPM (Certified Property Manager), CCIM (Certified Commer-cial Investment Member), or MAI (Member, Appraisal Institute) giveadditional assurance of qualifications. National associations will beable to provide you with local names and addresses of its members.

Another certified professional you should consider when planninginvestment strategies is the Certified Financial Planner (CFP). Theseexperts can help you determine whether or not this type of real estateinvestment is right for you. They have the professional background andeducation to properly evaluate your financial goals.

For additional help in locating consultants, look through local tele-phone directories in the cities where you plan to invest. These directo-ries can be found in the local library. Pick out names, addresses, andtelephone numbers of local consultants, and send them a letter of in-quiry like the one in Figure 4.1.

Once you’ve received your replies and have identified a number ofprospects, make a list of the ones you would like to interview. To savetime, try preinterviewing them by telephone before you set up an ap-pointment. If they sound knowledgeable, request a resume. Consultantsnot qualified or interested should be weeded out immediately to avoidwasting time.

Always verify references. Even if you’ve been given the names offriends or relatives, check them out anyway. Most people are honest.You’ll be able to read between the lines. For additional backgroundinformation, check with the local Better Business Bureaus, credit re-porting agencies, and professional associations representing the con-sultant’s designation(s).

PICKING THE RIGHT CONSULTANT 41

Beware of “Know It Alls”

Let consultants know up front that you’re interested in investing in mid-sized apartments. Don’t employ anyone who says, “Real estate is real es-tate. It doesn’t matter what the type or the size, I can do the job!” Beaware of the consultant who is willing to give you advice on any and allsubjects. Rather than appear dumb, people will expound on anything

Figure 4.1 Sample consultant letter.

Date

NameCompany NameAddress

Dear Consultant,I am interested in purchasing a midsize apartment complex in your area.As part of my investment plan, I will be employing the services of qualified

consultants, I am considering your firm. I have enclosed a questionnaire toassist me in evaluating your company.

Please complete and return it as soon as possible in the prepaid envelope.Your cooperation will be greatly appreciated.

Sincerely,

Your Name

Questionnaire

1. What services will you provide for me?

2. What types of clients do you generally serve?

3. What size and kind of real estate do you most of ten handle?

4. What type of reporting will you provide?

5. How are you compensated, and how do you set your fees?

6. Does your firm have affiliates? If so, who are they, and how do they affectour relationship?

7. What are your educational credentials and business experience?

8. What licenses and/or certificates do you hold?

9. How do you keep up-to-date in your field?

10. What references do you have?


and everything, even if unqualified or unknowledgeable. I can’t countthe number of times I’ve heard attorneys elaborate on real estate marketconditions, knowing all too well that they were completely off in leftfield. Beware of the “shade-tree” mechanic. Always make sure you havepeople working for you who have the expertise to get the job done.

GETTING THE MOST OUT OF YOUR CONSULTANT

The best way to get the most out of your meetings with consultants isto record them. You will be surprised to find how much you didn’thear when you play it back. Let the consultant know before you beginthat the meeting is being recorded and get approval. If there are anyobjections, get another consultant.

Controlling Fees

Your tape recorder can also help you control billing costs. Consultantswho bill on an hourly basis should give you a breakdown of hours (or afraction thereof) based on specific matters. For example:

Realty Law Corporation(monthly billing)

Phone conversation with client 0.25 hr.Read contract 3.50Prepare sales contract 2.75

Total 6.50 hr.Amount due @ $250/hr. $1,625

Make note of the hours on the tape recorder each time you usethe consultant’s services. Then when you receive the bill, compare thehours. If the bill doesn’t agree with your figures, ask to see support-ing documentation, such as copies of telephone bills and employeetime sheets.

Avoiding Unnecessary Billings

Remember, you’re working with an expert. Don’t be afraid to ask,“Why do you have to research everything?” You’re absolutely right inthinking they should have a strong background in the area of their ex-pertise. The more research, the more billable hours. Be careful!

Beware of the consultant who charges a flat work fee. I’ve talkedwith attorneys who charge $200 per hour for their time. But if you ask

GETTING THE MOST OUT OF YOUR CONSULTANT 43

the same attorney to prepare a living trust, the attorney might quoteyou a flat fee of $5,000, knowing full well that with the help of a secre-tary and a word processor, actual billable time won’t come close to thatfigure.

Insist on getting a written cost estimate before any work is per-formed. An experienced consultant should be able to do this. If the con-sultant cannot, find out why not. Unless you’re asking the consultantto do something that is outside his or her field of expertise, thereshouldn’t be any reason why an estimate can’t be given. If you are ask-ing for something outside of the consultant’s area of expertise, don’t.Get another consultant.

Protecting Yourself

All consultant reports should be in writing. Recommendations, esti-mates, interpretations, and opinions must be written down to avoidany misunderstandings. Your decisions are made based on the consul-tant’s input. Don’t be trapped into the “I said this instead of that” or “Imeant this instead of that” syndrome. The degree for potential liabilityis extremely high. Protect yourself by getting everything in writing.

Have the tapes transcribed or make written notes of your meetingswith the consultant. Be sure everyone involved receives a copy. Thenotes must reflect what took place at the meeting (and should also in-clude telephone conversations), the plan of action, and who is responsi-ble for what. Always protect yourself from other peoples’ failures.Having it down in writing helps.

Fee versus Commission

Always be cautious of the consultant that wants you to go in on his orher deal. The degree of objectivity becomes questionable, at best. Work-ing on a fee basis rather than on a commission reduces this conflict ofinterest also. It establishes a higher degree of independence among theparties, which is extremely vital in this kind of relationship.

Keeping Control

Probably the most important rule to remember while working with con-sultants is to maintain complete control. Consultants provide the sup-port for the decision-making process. It’s up to you to maintain controlby making the decisions. Don’t relinquish command to anyone. If youlose authority, you’ll end up losing your money.


The questionnaire that appears in Figure 4.1 will assist you in evalu-ating consultants.

YOUR KEY CONSULTANT

The key consultant to your success is the property manager. In terms ofoverall real estate background, the property manager is best suited forthe pivotal role and is captain of your team of experts. Working on aday-to-day basis managing the property, the property manager mustbe able to assist in both the acquisition and sale of your building.

Finding a Good Property Manager

What do you look for in a qualified property management company?The first consideration is location. It is important to use a firm that islocated in the same general area as the property. Proximity is impor-tant for smooth daily operations.

Be sure the firm you choose does not own apartments in the samearea as yours. There could be a conflict of interest, and you might findthat your units have a higher vacancy factor and operating costs thanthe apartments the firm owns. When concentrating on midsize apart-ments, make sure the management company has experience in this spe-cific field and is currently managing similar properties. Don’t be misledby the “you’ve seen one, you’ve seen them all” reasoning. There aremanagement procedures and techniques that are unique to differentkinds of real estate. Knowing which ones apply to midsize apartmentcomplexes will increase the likelihood of success.

Be Wary of “Mom-and-Pop” Operations

I prefer to use a medium-size property management company, ratherthan a “mom-and-pop” company. These kinds of operations usuallydon’t have the staff to do an adequate job. In addition to managingsmaller units, they are typically involved with real estate brokering.I’ve actually seen these operators give prospective tenants the key to avacant unit, rather than showing it themselves. This type of marketingeffort won’t do if you’re trying to keep vacancies down.

Be Just as Wary of the “Giants” in the Field

Larger property management firms are geared to institutional in-vestors. Midsize apartment buildings somehow get lost in the shuffle.Individual attention suffers. The needs of your building might have to

YOUR KEY CONSULTANT 45

wait until those of a much larger complex are met. Your building mightbe assigned to a new or relatively inexperienced property supervisor toprovide training.

Procedure Manuals Are Critical

Ask to see the operations or procedure manual of the firm. Read it andask questions. You’ll get a clear indication of how a property manage-ment company manages apartment complexes from the manual. Beleery of the company that doesn’t have one. In fact, do not considerusing a company unless they have a formal plan on how they manageapartment buildings.

What to Expect from Your Property Manager

Under no circumstances should you run the day-to-day managementoperations. Your role is to properly monitor the project in order to es-tablish effective policies and to make management decisions.

What support should your property management company provide?Ideally, they should be able to provide all services in the areas of acqui-sition, operation, and disposition of your property.

After you’ve pinpointed possible property locations, a good prop-erty management company should be able to give statistical, as wellas subjective, information concerning socioeconomic, political, anddevelopmental conditions. A quality firm should be capable of prepar-ing physical inspection reports, capital improvement requirements,and an effective operations budget.

During the operations phase, a competent property managementcompany will issue timely monthly operating reports that compare ac-tual income and expenses to budgets. They should be able to give you adetailed explanation of any major variances, and their representativeshould meet with you periodically.

During the sale phase of your property, your management firmshould be able to communicate with the potential buyers on your be-half regarding the building, and to assist in various inspections. Theyshould have no problem providing these services because it gives themthe opportunity to display their own expertise to the new buyers.

Controlling Property Management Fees

How much should you pay a property management firm? Paymentshould be based on the various tasks you want performed. In assistingyou with the acquisition, you should contract out on an hourly basis


that’s comparable in the area. Under no circumstances agree to an in-spection contingent on signing a management contract. You can readilysee where this could lead. More property managed equates to more in-come, a flagrant conflict of interest. Work with a reputable company,one that won’t recommend you buy the building just to get the man-agement contract.

Management fees are usually based on a percentage of the rents col-lected. Smaller projects pay a higher percentage than larger ones. Re-member, management fees are always negotiable. There are no fixedrates. Make sure all services and related costs are spelled out in writ-ing before you enter into a management contract.

It is important to note that fees based on the percentage of rents col-lected should not include other items such as total cash collected, pro-jected rents, gross possible rents, security deposits, and laundryincome, for example. Be careful. Know exactly what the rate is and howit’s applied.

If you want to give additional incentive to the property managementcompany, offer them a bonus based on the building’s performance. Itcould be based on net operating income or the overall improvement ofthe complex over a period of time, usually one year.

Traps to Avoid in the Property Management Agreement

In the chapter that teaches you how to manage your property manager,various techniques are introduced to assist in monitoring and control-ling operations. However, there are some important points that shouldbe emphasized at this time, including:

1. Do not sign a management contract that gives a managementcompany exclusive rights to sell or purchase your property. Itwill severely limit your ability to market it yourself or to arrangeto have others do it for you.

2. Be sure the contract has a provision for immediate cancellationupon written notice. Much can happen while you’re waiting fora contract to expire that is based on a 60- or 90-day cancellationclause. Typically, a 30-day cancellation clause is required for mostwritten contracts. That is standard for the industry.

3. Make sure that bills and expenses are specifically delineated tobe paid in the following order of priority by the property man-ager: insurance, all debt service, salaries, utilities and servicecontracts, and taxes and assessments. The last item to be paidshould be management fees and any leasing commissions. You

FINDING THE BEST ATTORNEY FOR YOU 47

want to make sure your investment is protected (insurance) andthat your mortgage is paid before any other expenses are paid.Some property management companies want to make sure that they and their vendors are paid first, but they will be verymotivated to quickly collect rents and fill vacancies if they getpaid last.

4. Compare the proposed staffing on your building to that of similarproperties in the area to find out what type of arrangements arecommon. State or local regulations may dictate a resident man-ager in a certain building size or with a number of units, so beaware of the laws. Make sure that the duties and responsibilitiesof all staff are spelled out in writing as part of the managementcontract.

5. The management agreement should specifically state the reportsto be provided to the owners (more details on what reports youneed can be found in Chapter 10). You tell the property managerwhat reports you need, they don’t tell you what they provide. Ifthey say they can’t provide the information that you want, findanother property management company.

FINDING THE BEST ATTORNEY FOR YOU

Your attorney must be familiar with the real estate laws in the jurisdic-tion of your property. An attorney in one state can’t give you good ad-vice on property located in another state unless the attorney knowsthe laws of that state. A copy of the Martindale-Hubbel Law Directory,found in many local libraries, will give you a list of lawyers, their back-grounds, and types of practice to assist you in finding a specialist.

As with property management companies, I prefer to use a medium-size law firm specializing in real estate. You can’t be too sure who’shandling your work with larger firms.

An experienced firm can actually reduce the total billable hours. Ex-perienced attorneys don’t have to continually research areas in theirfield of expertise.

Use the services of an attorney to assure yourself that all documentsaccurately represent the agreement, and that you’re adequately pro-tected. Your attorney must tell you what your exposure is and how to(1) either eliminate it, or (2) make provisions to deal with it.

Your attorney should be able to review the following importantdocuments: escrow instructions, title reports, lease or rental agree-ments, loan documents, and any other contract that pertains to thebuilding, such as laundry leases, and pool and landscaping contracts,


for example. The attorney’s written report must assert that these docu-ments accurately reflect the transaction.

In general, your attorney should point out potential problems on ab-solutely anything that might be out of the ordinary. Most importantly,your attorney should provide protection in case things go wrong.

Structuring Contracts to Avoid Litigation

All parties lose when they litigate; that is, all parties except the attor-neys. To avoid costly litigation, insist that all contracts contain a provi-sion for binding arbitration. Nonprofit groups, such as the AmericanArbitration Association, the Judicial Arbitration Association, and theJudicial Arbitration and Mediation Service, provide arbitrators (usu-ally retired judges) to settle disputes. Arbitration is relatively quickand inexpensive because it requires less disclosure and fewer legalmotions.

If you’re forced into litigation, try to assess the strength of your case.A good way to do this is to see if you can find an attorney who will takeyour case on a contingency basis. If you can’t, then seriously reassessyour position. The best move you can make before getting involved withthe entire legal system is to try face-to-face communication. This is thebest and least expensive way to resolve misunderstandings.

THE SECRET TO WORKING WITH ACCOUNTANTS

An accountant can help you with statistical analyses and income taxstrategies. The accountant should be able to give you a written reportthat includes projections and tax implications on your real estate trans-actions. Most accountants who specialize in real estate have computerprograms to facilitate this kind of reporting. In a matter of one or twosessions, the components of your transaction can be inputted into thecomputer, and with the help of specialized computer programs, theaccountant will be able to answer questions as to the “what ifs” scenar-ios and resulting tax implications.

Accountants, by the nature of their profession, tend to be con-servative. Accountants should be employed for their accounting andtax ability, not to decide whether your purchase is a “good deal.” Your investments must be extremely aggressive in order for you to be-come wealthy. Don’t be discouraged if your accountant gives yourreal estate deal a “thumbs down.” It’s an accountant’s nature! The ad-vice is given out of the fear of being aggressive rather than the invest-ment itself.

THE CONSULTANT WHO WILL SAVE YOU THE MOST 49

Remember, by conscientiously applying the lessons in this book,you will acquire the knowledge needed to make the right decisions.Never be afraid to act on this knowledge and your own convictions.

GETTING THE MOST FROM THE ESCROW AND TITLE COMPANIES

The key to getting a good escrow company is complete independence.Use a national title company to escrow the transaction whenever possi-ble. Smaller local companies are more susceptible to playing favoritesto selected clients. In addition, if interstate transactions are involved,communications improve when you use the services of a national firm.Again, use a company experienced in apartment transactions. A com-petent escrow company must display a high degree of proficiency intax-deferred exchanges, bulk sales transfers, prorations, and variousforms of ownership.

Another advantage in using a national title insurance company toescrow your transaction is the cost. As an incentive to purchase title in-surance, some companies reduce escrow fees. If the quality of the ser-vice remains the same, it ’s an excellent opportunity to save money.

THE CONSULTANT WHO WILL SAVE YOU THE MOST TIME AND MONEY

The one consultant who can save you the most time and money is a realestate investment broker. Notice we said investment broker. Once againwe ask you to work with a specialist. All real estate brokers do not havethe same qualifications. A real estate professional who you can rely onhas the Certified Commercial Investment Member (CCIM) designation.This designation is the result of a strenuous program of certificationthat is granted by the Realtors National Market Institute (RENMI). Fora list of all CCIM real estate agents in an area, write to RENMI, 630North Michigan Avenue, Chicago, IL 60611 (or call 312-440-8000).

You should be able to delegate many of the tasks involved in buyingand selling to a qualified real estate investment broker. However, keepin mind their services are not free. This has to be taken into considera-tion when calculating a rate of return. If the selling broker is also thelisting agent, according to agency law, the broker/agent primarily actson behalf of the person or entity to whom the broker/agent is contrac-tually obligated. So, if the selling broker is functioning as a listingagent, the broker/agent is primarily representing the seller. If you, asthe buyer, want independent representation, consider employing the


services of a real estate licensee using the sample contract shown inFigure 4.2.

An Effective Way to Save on Commissions

There is no such thing as a standard broker’s commission. Commis-sions are negotiable. Generally, the higher the selling price, the lowerthe commission. A reputable broker will not sell you a piece of prop-erty just to earn a commission. But, always be careful and analyze allpotential conflicts of interest.

Remember, agents working strictly on a commission basis, do not getpaid until the sale occurs. It’s important to negotiate the commissionand the services to be performed up front before anyone starts working.

Understanding How Multiple Listing Services Work

Most larger apartment buildings do not get put into the multiple listingservice (MLS) book. Members who belong to the MLS are required tosubmit all new listings, and/or changes, to the board of realtors literallywithin hours so that it can be disseminated to other board membersquickly. However, not all “hot” listings get on the board or, when theydo, it occurs in a matter of days, not hours.

The MLS book provides information on real estate activity for Real-tors. It is distributed by the local MLS boards to members who sub-scribe to the service. Some real estate boards make this informationavailable to the general public.

A knowledgeable investment real estate broker who belongs to theMLS service normally is in the best position to find properties. Thebroker’s continual full-time effort to stay abreast of market conditionsprovides a decisive edge in finding the best deals.

If you decide to use the services of a real estate investment broker,work with several. You should be exposed to as many properties as pos-sible. Be sure to let the broker know your parameters (building size,price range, down payment, age, unit mix, and so on). A good relation-ship with a qualified real estate investment broker can be your bestticket to wealth.

WHAT TO TELL THE BUILDING INSPECTORBEFORE AN INSPECTION

If the property management company does not have anyone on staffto do a physical property inspection, use the services of a building

51

Figure 4.2 Buyer’s broker employment agreement.


inspection company. Be sure you let them know before they do the in-spection that they will not be contracted to do any of the repair workrecommended on their inspection report. This will avoid any con-flicts of interest.

The report should list all items to be repaired or replaced, includingitemized costs and estimated dates the work should be performed.These items should be broken down on a unit-by-unit basis. This infor-mation will be useful when preparing budgets and when negotiating.If you question anything on the report, get a second opinion. Narrativedata detailing potential problems should be included in the report.

Whenever possible, use a local building inspector. The inspectorshould be knowledgeable about local codes, costs, and conditions af-fecting the building.

SAVING MONEY USING AN APPRAISER

The professional designation given to qualified real estate appraisers isMAI (Member, Appraisal Institute). Their reports give present marketvalue as of a specific date. Keep in mind, however, your main concernis with future market value.

The appraisal report will assist you in negotiating price and terms,applying for loans, and preparing budgets. A qualified appraisershould provide you with a detailed cost breakdown of repairs andreplacements.

When planning the financing of your acquisition, save time andmoney by employing an appraiser approved by the lender. Be certainthat the appraiser works for and is paid by you, not the lender. You wantthe appraiser to act on your behalf. Always have the appraisal companykeep several copies of the report on file so that original signed copies canbe sent to other lenders without incurring additional costs. Appraisalsare very expensive. Make sure you verify with lenders that your ap-praiser is on their recommended list.

You can find professional appraisers listed in the Yellow Pages of thetelephone book, or you can write to the American Society of Apprais-ers, Dulles International Airport, P.O. Box 17265, Washington, DC90041 for a list of appraisers in your area.

WORKING WITH LOAN BROKERS

Depending on market conditions, it may or may not be easy to get aloan. Normally you can save money on points (fees for obtaining theloan) by dealing directly with the lender. However, the savings on

SUMMARY 53

points may be more than offset if you end up with a bad loan. Loan bro-kers can usually obtain better financing for you because of their knowl-edge of the mortgage markets.

First, try to obtain a loan directly from a lender. Compare the lender’sfees to those offered by the loan broker, and choose the least expensiveone. Some loan brokers want an up-front fee for shopping for the loan.Try to get them to accept your credit report instead. When a broker pres-ents you with a legitimate loan commitment from a lender, a good faithdeposit may be requested. You shouldn’t give the broker any moneyuntil you’ve verified the commitment with the lender.

Any questions regarding a loan broker’s contract or the commit-ment letter, should be referred to your attorney before you sign anydocuments.

SUMMARY

One of the advantages of buying midsize apartment buildings is thatyou can economically employ the services of qualified professionals.Knowing how and when to use them both effectively and efficientlysaves you time and money. These experts help you reach your goalsfaster and with fewer headaches.

Under no circumstances should you abdicate control. This is the keyto effectively managing consultants. It is up to you to make the final de-cisions based on the recommendations and information supplied byyour team of specialists. Remember, the buck stops with you. Don’t passit on, or you will lose it!

55

5Buying in the RightPlace at the Right Time

TWO RULES FOR BUYING AND SELLING

How many times have you heard it said, “The three most importantthings to remember when investing in real estate is location, location,location”? Or, “If I’d bought that property 10 years ago, I would be amillionaire today.” Knowing what, when, and where to buy is not onlythe key to sound real estate investing, it is the key to all investing.

John Paul Getty said, “Buy when everyone is selling and sell wheneveryone is buying.” This simple statement represents the cornerstoneof our investment philosophy. When buying, find out where everyoneis selling, evaluate the area, and negotiate the best deal possible. Sellwhen everyone else is buying. This is our Standard Operational Proce-dure (SOP). In this chapter, you learn how to apply this SOP.

THE BENEFITS OF BOTTOM FISHING

Remember, there are always pockets of opportunity for real estate in-vestments. Good markets exist all over the world at varying times.Concentrate on weak markets, not weak properties. A weak market is

56 BUYING IN THE RIGHT PLACE AT THE RIGHT TIME

the most favorable condition in which to buy. Prices are depressed andprofit potential is high. Sellers just want to get out. Buying in a de-pressed market is called “bottom fishing.”

The Key to Evaluating Locations

Focus on areas where the local economy is basically strong and the cur-rent downturn is caused primarily by overbuilding. The U.S. Bureau ofthe Census publishes building permit activity for buildings five unitsand up for Metropolitan Statistical Areas (MSAs). Identify marketswith the largest gains in building permits from one year to the other. Ifyou discover a “construction bubble,” it could mean you’ve located anideal market. With a diversified local economy, the overbuilding shouldbe absorbed. A weak market caused by conditions other than overbuild-ing should be scrutinized carefully.

Apartment buildings often make money for the second owners inoverbuilt markets, not the first. Builders get paid for building and theywill keep on building as long as they get paid. More often than not,banks are the ones doing the paying.

The market becomes deluged with an excess of inventory. This iswhen you should step in.

Employment Trends

Base employment is probably the single most important factor con-tributing to the economic health of an area. In evaluating employmenttrends, be careful of construction employment. During boom-and-bustbuilding activity, the labor base can become distorted by constructionrelated jobs. If possible, eliminate construction employment figureswhen plotting trends. Predicting growth industries and where theywill be located can give you a further indication of where future em-ployment growth will take place.

Talk with the local city planner to determine the direction of citygrowth. Plans for shopping malls, universities, and business parkscreate a potential demand for employment and desirable apartmentlocations.

Demographic Factors Affecting Apartments

Demographic factors are also important in evaluating demand. Peopletend to marry later and divorce is on the increase, both of which resultin a larger single population. In addition, people are living longer, and

APARTMENT BUILDING CYCLES 57

we have the empty nest syndrome, as grown children move away fromthe family home usually into apartments. The parents no longer need alarge private home and many choose an apartment as well. The numberof households is increasing, and the size is decreasing. The affordabil-ity of single-family homes is also decreasing.

Demographically, look for an area in which there is a higher per-centage of females to males, younger and/or older adults as opposedto middle aged, singles rather than marrieds, smaller families overlarger families, and renters over nonrenters in evaluating favorablerental areas.

APARTMENT BUILDING CYCLES

The “when” to buy and sell is just as important as the “where.” Withbad timing you’ll strike out every time. To improve your timing, youmust become familiar with apartment cycles.

Cycles result from the influence supply and demand have on themarketplace. Economists spend countless hours trying to accuratelypredict them, and gurus for the current year are the ones who guessedcorrectly the previous year. As long as their crystal ball remains clear,they will continue to be called on for their advice. One false predictionand they are ousted from the Nostradamus Hall of Fame.

Apartment cycles are difficult to forecast. Yet, it ’s essential to haveprojections when buying and selling. Understanding them will giveyou the insight to make intelligent decisions.

Figure 5.1 shows the five phases of the apartment cycle. Note themost desirable times to purchase and sell.

The Five Phases of an Apartment Cycle

The five phases in an apartment cycle are a result of the interplay ofsupply and demand. They are:

Phase 1. Population increases, incomes rise, and the picture for em-ployment is rosy. As a result, vacancies are decreasing and apartmentrents rise sharply. New apartment complexes have been planned.Phase 2. Apartment project starts increase rapidly. All market indica-tors—rents and prices, recordings of deeds and building permits—reach high levels. Existing apartment complexes are being purchasedin a bidding war. To maximize profits, sell in this phase.Phase 3. Apartment projects come onto the market all at once. Infla-tion has increased quickly. The Federal Reserve Boards try to stop


inflation by increasing interest rates. Vacancy rates begin to creepup. Prices begin to level.Phase 4. Builders are having trouble selling their properties. Higherinterest rates result in high holding costs. Landlords are competingfor tenants because of the overbuilding. Foreclosures become morefrequent.Phase 5. Both unemployment and inflation continue at record rates.Renters double up to save money. Effective demand is decreasing.How far this phase will continue depends on the degree of over-building and lending policies. This stage will end and a new phase 1will begin when the general business economy starts to improve.The ideal time to purchase is during this phase.

MASTER APARTMENT ECONOMICS

Understanding the relationships between supply and demand is es-sential when determining location and timing in the apartment mar-ket. Figure 5.2 shows how the interaction of supply and demandaffects prices. The various markets are shown. The equilibrium pointis P-1, the current price. Increases in population due to a favorable jobmarket is curve D-2, with prices rising to P-2. A continued increase inpopulation results in a new demand, indicated by D-3, with a result-ing price of P-3. Higher prices result in building and a new supplycurve, S-2. The additional supply reduces demand, so prices drop to

Figure 5.1 Five phases of an apartment cycle. Source: The Center for RealEstate Studies.

Phas

e 1:

Beg

inni

ng o

f rec

over

y

Phas

e 2:

Rec

over

y pe

akin

g(t

ime

to s

ell)

Phas

e 3:

End

of b

oom

Phas

e 4:

Rec

essi

on

Phas

e 5:

Bot

tom

fish

ing

(tim

e to

buy

)

Phas

e 1:

Beg

inni

ng o

f rec

over

y

Time

Apa

rtm

ent B

uild

ing

Pric

es

MASTER APARTMENT ECONOMICS 59

P-4. The supply and demand relationship continues to change prices,which produce P-5 and so on.

To assess the supply side of the apartment cycle, these questionsneed to be answered:

• Where and when has construction taken place?• What has been built—apartments, commercial buildings, or sin-

gle family units?• What is the number of existing apartment permits?• What is the likelihood of more permit requests as a result of con-

struction costs?• How do local ordinances affect the issuance of permits?• What are the environmental factors?• Is construction expanding the city or is it in-fill?• How much buildable land is available?• Is the squared footage available for rent increasing rapidly?• Is in-fill causing the supply to remain level as older units are

being demolished?

Theoretically, as long as the supply is below the demand, the valueof the real estate will increase because of the ability to increase rents.If supply is greater than demand, the reverse is true; therefore, theability to raise rents is impaired. In fact, rents do tend to come down.

Figure 5.2 Apartment building supply and demand. Source: The Center forReal Estate Studies.

Sale

s Pr

ice

of B

uild

ing

Apartment Building Supply

P1

P2

P3

P4

P5

D3

D2

D1

S1

S2


An overabundance of buildable land is a negative factor in projectingpotential supply. Excess buildable land causes rapid market changeswhen builders decide it’s profitable to start building again.

In picking locations within a city, choose apartments that have a cer-tain degree of resilience even in down markets. Complexes near publictransportation, urban centers, and beachfront property fare much bet-ter than ones located elsewhere. The closer an apartment complex is toemployment areas, the more desirable it is.

Demand for apartments is created by increases in certain segmentsof the population. Low-paying jobs tend to create a larger supply ofrenters than higher-paying jobs. As a result, buying apartments in blue-collar neighborhoods is preferable. Wages paid in these neighborhoodsare more compatible to paying rent than they are to paying mortgages.

The single most important factor in gauging demand is job creation.Cities that foster an atmosphere that will bring about greater employ-ment will increase the demand for apartments.

Demand for apartments is also related to changes in affordability.The fewer people able to purchase homes, the greater the demand forrentals and vice versa. Another important factor affecting supply anddemand is the availability and cost of mortgage money. Interest ratesplay an important role in determining demand. When rates are high,fewer people can afford to buy houses, and the demand for mortgagemoney decreases. Higher interest rates also prevent builders from build-ing, thereby reducing supply. Lower interest rates, on the other hand,tend to increase building activity, and buyers can qualify for loans morereadily and are more able to buy. Demand for houses increases, whilefor apartments it will decrease.

All Markets Rebound Eventually

Knowing the elements of supply and demand is both informative andeducational. Knowing how to apply them is what makes you wealthy!The procedures in this chapter help you determine the best locationsand time to purchase midsize apartment buildings.

It’s important to note that virtually all markets will rebound in oneway or another. Sooner or later the economies of supply and demandwill take over to create opportunities for the smart investor.

THE ANALYTICAL APPROACH TO LOCATING GOOD AREAS

Many real estate books recommend buying property in good areas, butthey fail to tell you where they are or how to locate them. The ability to

ANALYTICAL APPROACH TO LOCATING GOOD AREAS 61

accurately project vacancies and rental rates is the key to finding goodlocations. The more proficient you become at forecasting, the greateryour chances are for success.

Where do you start? Start with building permits. A construction bub-ble or sudden increase in total building permits may be an indicationof a good area. The Bureau of the Census publishes several pertinent re-ports. Write to the Bureau of Census, U.S. Department of Commerce,Superintendent of Documents, U.S. Government Printing Office, Wash-ington, DC 20402, and ask for the Bureau of the Census Guide to Programsand Publications, Subjects and Areas. This guide contains charts that de-scribe the statistical information available in various Census Bureaupublications since 1968 and is fully indexed.

Once you’ve identified locations based on building permits, comparecurrent selling prices of apartment buildings with replacement costs. Ifselling prices are below replacement costs, it may be that the area haspotential. Local building and real estate associations should be able toprovide you with data on selling prices and building costs. Marshall &Swift publish a book, Residential Cost Handbook, that details the costs ofvarious apartment buildings based on locations throughout the UnitedStates and Canada. It can be found in many local libraries.

Always supplement statistical data with information from newspa-pers and business and real estate publications. Knowing where jobs arebeing created and where layoffs are occurring is vital in determininglocation. Projections on growth rates, cost of living, and quality-of-lifesurveys are also helpful.

Determining the Best Time and Place to Buy and Sell

The following historical (six years or more) data, as well as forecast(one year or more) data, should be used in computing good locations:

1. Building permits2. Employment3. Household income4. Number of households5. Median house prices6. Vacancy factory7. Rental rates

Be careful when gathering data. You will need reliable, accurateinformation. The sources listed in each of the following categories arerecommended. Please use them whenever possible. Data must also becompatible. For example, when working with employment statistics,


make sure your figures include similar employment classificationsfrom year to year. That is, don’t use military employment in one reportand exclude it in another, or the medium home price can then change toaverage home price. Be consistent.

BUILDING PERMITS Permits issued each year for apartments (fiveunits and up) will assist in tracking building cycles (Figure 5.3). Sincea time lag exists between issuance and completion, having advance no-tice of what’s coming is important.

Sources: Two good sources are local city planners and HousingUnits Authorized by Building Permits and Public Contracts found ineither your local library or Department of Commerce, Bureau of theCensus, Building Permit Division, Washington, DC 20230, (301) 763-7244.Forecast: Local planning departments, banks, colleges, building as-sociations, and chambers of commerce provide projections. If fore-casts are not available, estimate permits based on historical cycles.

EMPLOYMENT Employment is a key figure. Look at the number of people who are employed rather than the unemployed. A new job

Figure 5.3 Multifamily housing permits. Source: The Center for Real EstateStudies.

1995

400

350

300

250

50

200

150Tho

usan

ds

100

01996 1997 1998 20001999

Year20022001 20042003 2005

ANALYTICAL APPROACH TO LOCATING GOOD AREAS 63

created in one area of employment results in additional jobs in otherareas. For example, each time a factory worker is hired, it creates addi-tional work (and jobs) for the baker, grocer, mechanic, doctor, builder,and so on.

Source: County Business Patterns can be found in your local libraryor Department of Commerce, Bureau of the Census, County Busi-ness Patterns Branch, Washington, DC 20233, (301) 763-5430.Forecast: Bureau of Labor Statistics (BLS) in your local area, thelocal department of employment, or local chamber of commerce aregood sources.

HOUSEHOLD INCOME Household income influences the value ofapartments. As income rises, tenants’ ability to pay higher rents in-creases, which, in turn, increases the value of the property. There is,however, a point at which household income will rise sufficiently to af-ford a mortgage payment rather than rent. At this point, rents willeither level off or decline.

Source: Sales and Marketing Management published by Bill Commu-nications, 633 Third Avenue, New York, NY 10017, (212) 984-2434.They provide a figure known as Effective Buying Income (EBI) thatis excellent for your computation.Forecast: Sales and Marketing Management also publishes a five-yearforecast, or try Editors and Publishers Market Guide, 11 West 19thStreet, New York, NY 10011, (212) 675-4380.

NUMBER OF HOUSEHOLDS Households rent apartments not indi-viduals. A household may consist of one or many people (Figure 5.4).Therefore, using total population will distort the calculation.

Source: Sales and Marketing Management published by Bill Commu-nications, 633 Third Avenue, New York, NY 10017, (212) 984-2434.They provide a figure known as Effective Buying Income (EBI) thatis excellent for your computation.Forecast: Sales and Marketing Management also publishes a five-yearforecast, or try Editors and Publishers Market Guide, 11 West 19thStreet, New York, NY 10011, (212) 675-4380.

MEDIAN HOME PRICES Median home price levels fall half way be-tween those homes priced above and those priced below. This differsfrom an average home price, which is derived by dividing the number


of homes by their total value. An average home price can be easily dis-torted by extreme values.

Sources: The National Association of Realtors Library, 430 NorthMichigan Avenue, Chicago, IL 60611, (312) 329-8200, or FederalHousing Finance Board, 1777 F Street N.W., Washington, DC 20006,(202) 408-2967.Forecast: If not available from local sources, base forecast on histor-ical cycles.

VACANCY FACTORS The goal of this analysis is to project changes invacancy rates. When vacancy rates increase or decrease substantiallyin any one year as compared to their historical pattern, it is an indica-tion to either buy or sell (Figure 5.5).

Sources: Universities and local real estate firms may have data. De-partment of Commerce, Bureau of the Census, Housing and House-hold Economic Statistics Division, Washington, DC 20233, (301)763-8165.Forecast: Provided by the analysis.

RENTAL RATES The final goal of this analysis is to use historicalrental rates to project future rents. These rates can then be used to cal-culate the conservative internal rate of return (IRR).

Figure 5.4 Multifamily household formations. Source: The Center for RealEstate Studies.

1996–2000

2,500

2,000

1,500

Hou

seho

lds

(in

Tho

usan

ds)

1,000

5002001–2005 2006–2010

Years

181.25

1,167.85

2,110.97

SUMMARY 65

Source: The American Chamber of Commerce Research Associa-tion (703-998-4172) gives the cost-of-living index (rental factor) forvarious cities.Forecast: Provided by the analysis.

These seven factors, used in correlation with the least-squares methodof projection, give you the ability to forecast both vacancy and rentalrates. The computations are time consuming if done manually. TheCenter for Real Estate Studies (CRES) publishes a quarterly newsletterthat projects vacancies and rental rates for many Metropolitan Statisti-cal Areas using similar data. To further analyze local areas, we useCRES’s LS STAT analysis program. It is easy to use and designed toforecast both vacancy and rental rates. For more information on thenewsletter and software package, see page 226.

SUMMARY

There is no easy way to predict areas of opportunity. This chapter fo-cused on a proven statistical methodology to do so. Correct statisticsgive you the edge when buying and selling apartment buildings. How-ever, also crucial to your success are the subjective evaluations you makebased on your research. The proper use of this methodology will helpyou determine the areas of opportunity in which to build your fortune.

Figure 5.5 Rental housing vacancy. Source: The Center for Real EstateStudies.

Perc

ent

Year

10.0

9.5

6.0

5.0

8.5

7.0

9.0

5.5

8.0

7.5

6.5

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

67

6Easy Steps to LocatingGood Property

STARTING YOUR SEARCH FOR QUALITYAPARTMENT BUILDINGS

Once you’ve pinpointed the location, it is time to look for the rightproperty. Where do you start the search? First, find out who’s selling.The best place to look is in the classified section of the news-paper under residential income or investment properties. To locateout-of-town newspapers, look in the Yellow Pages of the telephonebook under “newspapers” or “news dealers.” You can find local pa-pers listed in the Gale Directory of Publications and Broadcast Media inlocal libraries. You can also find out-of-town newspapers in the refer-ence section of the library or on the Internet. If not available there,subscribe to the Sunday editions using the Gale Directory. The major-ity of real estate advertisements are published on Sunday. By readingabout the community, you can begin to formulate your own views ofthe area.

c06.qxd 4/5/04 11:35 AM Page 67

68 EASY STEPS TO LOCATING GOOD PROPERTY

MAKE THE LENDERS WORK FOR YOU

Contact lenders for additional leads on apartment buildings for sale.Because you are buying in areas where the local economy is currentlyweak, banks and S&Ls may have property they want to sell.

Lenders are in the business of lending money, not property manage-ment. Having an inventory of Real Estate Owned (REOs) ties up funds.As a matter of policy, banks and S&L’s profits come primarily fromlending, not managing properties.

Some financial institutions have their own real estate and businessresearch departments. They promote community awareness and are in-strumental in fostering a healthy business climate. Your questions re-garding the local economy can be directed to these organizations.

USE MOTIVATION TO YOUR ADVANTAGE

Owners who advertise and actively market their property are moti-vated to sell. You will spend less time negotiating with a motivatedseller than you would with one who’s not. Some owners have egos thatcontinually need stroking. Don’t waste your time. It’s far better towork with someone who really wants to sell.

THE SECRET OF WORKING WITH REAL ESTATE LICENSEES

Consider using the services of local real estate agents to help you find property. Remember what you learned in Chapter 4 about work-ing with consultants. The secret of working with real estate licenseesis to communicate your specific needs. Basically, they should be asfollows:

1. Midsize apartments2. Under 20 years of age3. Preferably with pitched roofs4. The correct unit mix for the area5. Highly leveraged 10 percent down payment (or less)6. Offering seller financing7. Deferred mortgage payments

This should give the real estate agent enough to work with to locatethe right apartment building for you.

c06.qxd 4/5/04 11:35 AM Page 68

A GOOD SOURCE FOR LEADS 69

A SAMPLE ADVERTISEMENT FORBUYING APARTMENTS

If you still are not getting anywhere locating a building, try runninga variation of the following ad in the local newspaper for six to eightweeks:

Responses will vary depending on the availability of property andseller motivation. The ad might generate calls from real estate agentswanting to establish your criteria for buying. Be cooperative. You wantas many people as possible helping you locate property.

A GOOD SOURCE FOR LEADS

When looking through the classified ads, be sure to turn to the “Apart-ments for Rent” section. Owners offering free “giveaways” such as rent,vacations, microwave ovens, and so forth, are usually having a difficulttime renting. This could be a temporary situation and, depending onwhat your research has uncovered, you might nab yourself a good deal.

Classified AdsWANTED

MIDSIZED APARTMENTS

WILL PAY FAIR PRICE

WITH SMALL DOWN PAYMENT

QUICK CLOSING

PLEASE SEND SET-UPS TO: ________OR CALL ________or_______________

c06.qxd 4/5/04 11:35 AM Page 69


USING ACQUISITION CARDS

Create an acquisitions follow-up file. Ads of interest should be cut outand taped to 3 × 5 index cards. File numerically, according to telephonenumbers. Important names, follow-up dates, and comments should beentered on these cards. You will know if the ad changes or when theproperty is put back on the market simply by checking the telephonenumbers. Review your comments. You may want to pursue a lead again.Using this follow-up system will save you a great deal of time and, insome cases, a great deal of embarrassment.

GETTING SELLERS TO TALK TO YOU

Once you have a list of prospective buildings, you should obtain addi-tional information. When you request more details about the proper-ties, you are, in effect, asking for a set-up sheet (Figure 6.1).

Sellers will usually ask whether or not you are a principal or a realestate agent. If you hold a real estate license, please so indicate, but letthe seller know that you are buying as a principal. Sometimes sellersdo not like to deal with real estate agents because they suspect theagents are just trying to get listings. Let the seller know, in no uncer-tain terms, that you are a qualified principal. Present yourself as a“real player.”

Reading a Set-Up Sheet

The set-up sheet simply lists essential information about the property.It gives just enough facts to make a broadbrush determination as towhether or not you are going to proceed further. The standard form inFigure 6.1, or slight variations of it, is used in most states. It is compre-hensive enough to do a preliminary analysis of the property.

OPENING STATEMENTS

Location. The top lines of the set-up sheet give the address of theproperty. With the help of a local street map, it can be determined ifthe building is located in a desirable area. In picking locations within acity, try to group them by first choice, second choice, third choice, andso on. Work on the location groups according to preference. Your firstchoice might not yield any interesting prospects, but you will at leasthave a basis of comparison with properties in other neighborhoods.

c06.qxd 4/5/04 11:35 AM Page 70

71

Figure 6.1 Multiple dwelling units/apartment set-up sheet.

c06.qxd 4/5/04 11:35 AM Page 71


Have and Want. You can ascertain the seller’s plans by reading the“have” and “want” parts of this section. The seller can indicate whetherthe units are old or new, fixer-uppers or garden type, governmentalor nongovernmental assisted. You should be looking for newer garden-type, nongovernmental-assisted rental units. Make this your firstchoice. Other choices should be combinations of the above. Your lastchoice should be governmental-assisted programs.

Motivation. Motivation and wants go hand in hand. The seller mightbe motivated because business capital is wanted; therefore, the sellerneeds to be “cashed out.” It would be very difficult for this seller to as-sist in the financing. If the motivation is to reduce taxes, seller financ-ing or a trade might be attractive. Structuring the transaction to fulfillthe seller’s needs might be the deciding factor to your getting the deal.Understanding motivations and wants will help you formulate the bestdeal for all parties.

Gross Equity. The listing price less existing loans represents theseller’s gross equity. Knowing this will help you structure the offer. Ifthe seller has a considerable amount of equity, you might be requestedto obtain new financing to get more cash for the seller. If the sellerdoesn’t need cash, she or he may be willing to carry paper (loans) andnot disturb the existing financing.

Ideally, existing loans with low interest rates should be retained,and a low interest note that accrues should be created for the remain-ing equity. Sellers who are willing to finance the purchase in this waycan do so through the use of a wraparound loan. It can be an excellentmethod of financing for both the buyer and seller. Sellers get a securemonthly annuity, and buyers are able to use leverage and receive cashflow. Both obtain significant tax savings.

MAKING SURE THE DOLLARS MAKE SENSE The financial analysissection of the set-up sheet shows the figures that will determinewhether or not the dollars make sense. At all times, work with actualfigures, not projections or estimates. Some set-ups show projected in-come and expenses to paint a rosy picture. Make your own projectionsbased on your independent research, not anyone else’s.

At this point, you may want to compare the financial informationon the set-up sheets with those published by the Institute of RealEstate Managers (IREM), or you may want to confer with your con-sultant. IREM publishes a detailed annual breakdown of operating

c06.qxd 4/5/04 11:35 AM Page 72

GETTING SELLERS TO TALK TO YOU 73

income and expenses of apartment buildings by square footage. Infor-mation is cross-referenced by:

Furnished unitsBuilding ageUnfurnished unitsBuilding size

This data includes the United States and Canada, and represents in-formation received on over 9,000 buildings. Details on how to analyzethese figures will be presented later. Your main objective now is a quickreview to determine if you want to write the offer. Don’t spend too muchtime at this point. Wait until the property is under contract.

Capitalization Rate. This section contains one of the most importantfigures you will ever use in evaluating apartments. It is called the cap-italization rate (cap rate). It is calculated by dividing the net operatingincome by the listing price. The lower the rate, the higher the sellingprice. Conversely, the higher the rate, the lower the selling price.

To figure the selling price using the cap rate method of evaluation,apply this formula:

For example, if the net operating income is $100,000 and the caprate is 10 percent, the selling price would be $1,000,000 ($100,000 ÷10%). Lowering the cap rate to 8 percent increases the selling price to$1,250,000 ($100,000 ÷ 8%). Raising it to 12 percent reduces the sellingprice to $833,333 ($100,000 ÷ 12%).

Gross Rental Multiplier. The gross rental multiplier (GRM) or grosstimes factor computation is also shown in this section of the set-upsheet. It is calculated by dividing the listing price by the gross sched-uled income. It is a simple, quick, rule-of-thumb approach to evaluat-ing property.

In order to make a fast evaluation of the selling price, multiply theGRM by the gross income generated by the property. Use the formulabelow to calculate selling price:

Selling price = GRM × Gross income

Selling priceNet operating income

Cap rate=

c06.qxd 4/5/04 11:35 AM Page 73


If the property generates a gross income (includes all income—rents,laundry rooms, and so forth) of $100,000 per year and the GRM is 9, thenthe selling price would be $900,000 ($100,000 × 9). By lowering the GRM,you also lower the selling price. For example, if the GRM is 7.5, the sell-ing price would be $750,000 ($100,000 × 7.5). As a rule of thumb, stayaway from properties with a GRM higher than 7.5 unless you can be con-vinced you got a real good deal.

Since income items included in gross scheduled rents are not stan-dardized on all set-ups, we prefer using the cap rate to make out pre-liminary evaluations.

Assessed Valuation. Based on the property tax records, approximatevalues for land and improvements (the building) can be calculated.There is a correlation between assessed value and market value. Know-ing what it is will give you an indication of the value of the property.Your consultant or the property tax assessor should be able to assist youfurther.

For depreciation of improvements, the Internal Revenue Service(IRS) applies the same ratio of land to building as shown on the prop-erty tax bill. Have a qualified appraiser value the improvements, also.The IRS will accept such an appraisal. If it comes in higher, you will beable to deduct more for depreciation, giving you a greater tax savings.

Legal Description. This section contains a legal description of the prop-erty. When obtaining a preliminary title report, knowing the legal de-scription will help the title company in the title search. It’s vital toknow the exact location of the property and who the recorded ownersare when negotiating.

Make your offer directly to the owner unless you are certain theowner is being legally represented by an agent. Agents sometimespurport to represent sellers when, in fact, they don’t. This is done sothat they can get in on the deal hoping to make a commission. Re-member, you have more flexibility on price when commissions don’thave to be paid.

Title reports give the legal location of a building. A set-up mightshow that the property is located in one city, but the title report showsanother location. The title report has a higher degree of accuracy. Whyis this critical? If a property is located in the “wrong” city, even if it ’sjust across the street, market values can change drastically. The prelim-inary title report lets you know the legal location of the property.

It will also reveal other items affecting the title, such as mortgages,mechanic liens, judgments, and restrictions. Knowing what’s on the

c06.qxd 4/5/04 11:35 AM Page 74

GETTING SELLERS TO TALK TO YOU 75

title has a bearing on how you write the offer. If you’ve established agood relationship with a title company, preliminary title reports can beobtained free of charge.

MAXIMIZING GROSS RENTAL INCOME

Schedule of Income. Rental income plays an important role in evaluat-ing apartment complexes. You should know what the going rents are inareas under consideration. Your property manager will be able to helpyou determine this.

When analyzing locations with a high percent of families, the unitmix should show more three-bedroom units and fewer single units. Theopposite applies to senior citizens. Knowing the household size will dic-tate the most desirable unit mix.

If children are in the complex, it should be close to schools, parks,and day care centers. Adult complexes rent better close to shopping,recreation, and services. Senior citizens prefer living near medical ser-vices, community centers, and bus lines.

A building on a main street has more visibility than one set back oron a dead-end street. The more visible it is, the easier it is to rent.

Apartments in good neighborhoods close to shopping centers, em-ployment, and churches command higher rents. The further outsidethese neighborhoods, the lower the rents. Properties located in areaswhere there is little or no room for development, such as shorelines orhillsides with views, also tend to command higher rents.

Rent per square foot is a good method of evaluating properties. Set-ups showing rent per square foot can be compared for credibility usingIREM’s figures. Square foot rents are generally higher for newer andsmaller units.

Rents for furnished units will be higher than unfurnished. Whencalculating the market value of an apartment, discount rents attributa-ble to furnished units. Income generated by the furnishings can be de-termined by comparing differences in rents between furnished andunfurnished apartments or by contacting a furniture rental company.

Depending on location, it may be necessary to furnish units just inorder to rent them. However, remember that there are fewer managerialproblems renting unfurnished units than there are renting furnishedones. Furnished units historically have higher turnover rates. Higherturnovers equate to higher maintenance costs.

The GRM method will produce a higher valuation for furnishedapartment buildings than for unfurnished ones if the rental value ofthe furniture is included in gross income. Be aware of this.

c06.qxd 4/5/04 11:35 AM Page 75


HANDLING OTHER INCOME There are two theories on classifyingother income for valuation purposes:

1. The apartment should be valued based on unit rents only.2. All income regardless of its nature should be used.

When computing the cap rate, net operating income is used.The entire apartment complex generates both income and expenses;therefore, including all income will not distort the computation. Ifthe GRM method is used, only include income attributable to rentalunits. Other items of income, such as laundry revenues, interest in-come, or garage income, are not directly related to a unit itself andwill distort comparisons.

Apartment Operating Expenses. The set-up should show only actual fig-ures; no projections.

When you purchase an apartment building, a change of ownershipis recorded, which sometimes triggers a reassessment of property val-ues that, in turn, affects property taxes. Don’t forget to estimate whatthese new taxes will be when calculating operating expenses.

Preferably, tenants should pay all utilities. Avoid master meteredbuildings. Due to the problems associated with the energy crisis, utilitybills are, and will continue to be, a constant managerial headache. Newerbuildings are usually constructed with this in mind. Older buildingswere often not. Consider having metering devices installed in mastermetered buildings to allocate utility costs to tenants.

Always include a charge for management expense, even if it ’s notshown in the set-up.

Loan Information. This section contains several areas to help evaluatethe property. Knowledge of the existing loans will help determine howyou structure the offer. If the underlying loans can be left in place andthe terms are acceptable, consider either assuming the existing loans ortaking them subject to. Have your consultant calculate what the newmonthly mortgage payments will be. It’s important to know for cashflow projections purposes.

The less cash paid on the mortgage means the more available foroperations. Your goal is to get the highest interest deduction allow-able with the least amount of cash outlay. This can be accomplishedwith the cooperation of the seller. Have the seller carryback second-ary financing and accruing as much interest as possible. Then,arrange to have accrued interest paid at a later date after rental in-come has increased.

c06.qxd 4/5/04 11:35 AM Page 76

SUMMARY 77

Under the subheading “Other Terms . . . Remarks,” sellers can in-dicate their interest in taking stocks or bonds, other property, or pro-fessional services as part of the down payment. Agents use thissection to disclose any special features. It should be noted that up-scale locations require more amenities to attract tenants, such asgarages, recreation rooms, weight lifting facilities, saunas, extensivelandscaping, and others.

Additional Information. A picture is worth a thousand words when re-ferring to apartment buildings. Some set-ups include pictures. If theydon’t, this section will help you at least paint a mental picture of theproject. Spaces marked with an “X” indicate a yes answer.

Generally, the newer the building the more desirable and the fewermaintenance problems. Like anything else, however, it all depends onhow well the building was maintained. As a rule, try to buy buildingsunder 20 years of age.

The type of construction affects the operating expenses of the build-ing. Brick has fewer maintenance problems than stucco, stucco fewerproblems than wood, stairs fewer problems than elevators, blinds fewerthan drapes, pitched roofs fewer than flat, and so forth. Your local con-sultant will be able to advise you on how climatic conditions affect var-ious types of constructions.

The more landscaped grounds available, the more desirable to thetenant—the more easily rented, and the more expensive to maintain.Knowing the size of the lot(s) and the number of buildings will helpyou evaluate the open space in terms of landscaping costs.

More amenities mean more maintenance but fewer vacancies. Onealways has to be weighed against the other when analyzing the bottomline. Favor the buildings with amenities. The more desirable a projectis, the fewer tenant problems.

Broker Information. The bottom section of the set-up sheet tells who tocontact regarding the property. If you’re being represented by an agent,your agent should work directly with the listing agent. The fewer agentsinvolved in the transaction, the fewer the problems regarding commis-sion splits. I’ve seen agents lose a deal, rather than agree to a commis-sion split. Not only did they lose, but the buyers and sellers lost as well.Fewer is better!

SUMMARY

In this chapter, you’ve learned how to read a set-up sheet that is de-signed to give you the highlights of a property. Your initial review

c06.qxd 4/5/04 11:35 AM Page 77


should be broadbrush. You want to look at as many set-ups as possible.Don’t spend too much time on any one. You’re only trying to decidewhether or not you want to make an offer. Even in a down market, goodproperties tend to move quickly. If you’re spending countless hours an-alyzing set-up sheets before you make an offer, you might lose a prof-itable opportunity. Remember, if you look too long, you’ll never leap!How you make that leap is covered in the next chapter.

c06.qxd 4/5/04 11:35 AM Page 78

79

7Writing an Offer ThatWill Be Accepted

After you’ve looked at several set-ups and have established a prioritysystem, you should make contacts regarding the property—preferablywith the owner. If the contact is an agent, find out who will make thefinal decisions. Here are four questions to ask prior to writing the offerthat firmly establishes your parameters for buying:

1. Will the seller allow me to buy the property either subject to orto assume the existing loan(s)?

2. Can I pay 10 percent (or less) as a down payment?3. Will the seller take back paper (assist in the financing) and ac-

crue monthly payments?4. Can I make the offer based on a favorable capitalization rate of 8.5

percent or more?

If the answer is yes to most of these questions, prepare an offer im-mediately. If the answer is no, thank the seller for the time, and leaveyour telephone number in case the situation changes and the sellerchanges his or her mind.

c07.qxd 4/5/04 11:36 AM Page 79

80 WRITING AN OFFER THAT WILL BE ACCEPTED

Don’t be discouraged if you get all negative answers. Rememberthat you’re buying in a down market—make some slight modificationin either the price and/or terms based on responses, and submit anoffer. Desperate sellers won’t always let you know how anxious theyare to sell; however, they might respond to a written offer.

When talking with sellers, it ’s possible to ascertain their degree ofmotivation. Knowing how “hot” or “cold” they are helps establish astarting point in your negotiations.

WHEN TO USE THE 80 PERCENT RULE

Try to get the seller to reveal the lowest price and terms that would beacceptable before making your offer. If the price fits within your pa-rameters, submit the offer at that price. If not, start at 80 percent of thelisting price (the price shown on the set-up sheet).

Your acquisition plan is to use as much leverage as possible. Try not topurchase a property with more than 10 percent down. We prefer payingslightly more for an apartment complex rather than increasing the downpayment. Make the price flexible; not the terms. The number of proper-ties and active buyers in the market should determine whether or notyou perform a perfunctory or detailed analysis of the apartment com-plex. Few properties and many buyers won’t allow much time for re-search and a detailed property analysis. If the conditions dictate, makethe offer as quickly as possible using the 80 percent rule. If you havemore time, prepare a more detailed analysis.

GETTING THE SELLER’S ATTENTION

When talking with sellers, let them know you’ve researched theirproperty. If convenient, either you or your consultant should do a driveby (look at the property) before making contact. Sellers don’t like to re-ceive offers from buyers who haven’t at least seen their property. Theyfeel that you’re wasting everyone’s time just “throwing out” offers.

Use a Written Offer

Why do you write an offer in the first place? Why not go directly intoescrow? Buyers write offers to make sellers aware of their intentions.It’s as simple as that. If the seller’s expectations are the same as thebuyer’s, they have a legally enforceable contract. Right? Wrong! Onlywhen both parties agree in writing does a legally binding contract exist.

c07.qxd 4/5/04 11:36 AM Page 80

A PURCHASE OFFER DESIGNED FOR SUCCESS 81

Never forget that. There are some exceptions, but if you stick to thisrule, you will eliminate a lot of grief.

You want a written contract because people change their minds. It’sexpensive to make a conscientious effort to perform a due diligence (dis-covering everything you possibly can about a property), and then findout that the seller has different thoughts. When properly written, theoffer to purchase will prevent this. Any changes can only be made withthe mutual consent of all the parties.

While under contract, the seller is prevented from selling the prop-erty to someone else. The contract gives you certain enforceable rightsin the property.

A PURCHASE OFFER DESIGNED FOR SUCCESS

Figure 7.1 is a sample offer. Note its conciseness. It is not a legal-size,eight-page, small-print, initial-here document to scare away sellers, orto send them running to their attorney. Professional investors like theformat. Its easy in understanding and straightforward approach ac-count for the favorable acceptance it has received.

When making an offer, we send a package that contains our finan-cial statement, track record, covering letter, and the deposit check. Weinclude as much information as possible on our financial capabilities soas to establish creditability.

Key components of the offer are:

Date: The date establishes the beginning of the acceptance period.Acceptances received after the expiration period can either be ac-cepted or rejected by either party. However, if the offers/counterof-fers are accepted within the allowable time frame, a legally bindingcontract is created.Address: Using the street address at this point is acceptable. Lateryou will want to verify the legal description by reviewing the pre-liminary title report.Property: Use the name of the complex for further identification. Listthe number of units (by bedrooms and baths) as shown on the set-upsheets. It puts the seller on notice that you’re relying on that infor-mation. Be aware of the neighborhood. Large concentrations of fam-ilies require more bedrooms per rental unit than singles.

It’s important to have the right unit mix to keep vacancies low.However, don’t keep them too low at the expense of aggressive rentraises. Always try to be the rent leader rather than a follower. The ul-timate value of the building depends on ambitious rent raises.

c07.qxd 4/5/04 11:36 AM Page 81

82

Date

OFFER TO PURCHASE

ADDRESS: (as shown on set-up sheet)PROPERTY: (name of complex)

(number of apartments according to bedrooms and baths)PURCHASE PRICE: (80 percent of asking price or lower)DOWN PAYMENT: (10 percent of purchase price or lower)DEPOSIT: (1 percent of purchase price)FINANCING: Buyer to purchase subject to the existing financing. Sellerto take back equity in the form of an assumable mortgage at percentinterest. First 24 months interest to accrue; next 24 months, pay percent,accrue percent; the remaining 36 months pay percent. Principaland accrued simple interest due at maturity.

THIS OFFER TO PURCHASE IS SUBJECTTO THE FOLLOWING CONTINGENCIES:

1. Approval of tit le report, books and records, physical inspection reports, andloan documents, or any other information requested by buyer within 10(ten) working days from the receipt of same.

2. Seller shall furnish a report from a licensed pest control operator showingproperty to be free and clear of any visible infestation from termites, dryrot, and fungi. Escrow holder is instructed to pay for said report and/or workcompleted (including all direct and indirect costs resulting from tenting)from funds due Seller at close of escrow.

3. Buyer ’s rights hereunder may be assigned to a partnership, corporation, orother party, and any such transfers shall have all the benefits includingrights of specific per formance, damages, and enforcement of warranties,that Buyer has under this agreement.

4. Buyer to have final approval of any rental agreements, service contracts,and/or leases during escrow period.

5. Seller to deliver marketable tit le and warrants at closing that, to the best ofthe Seller ’s knowledge, no part of the property is in violation of any exist-ing codes, health or safety regulations, and is not involved in any govern-mental or judicial proceedings.

6. Buyer has the right to extend the date for closing of escrow by releasing theSeller through escrow an amount equal to one-quarter of one percent of thepurchase price for each 30 day extension requested, to be applicable to thepurchase price, with Buyer to maintain at all times the current deposit, asset out in this Agreement, in escrow.

Figure 7.1 Sample purchase offer.

c07.qxd 4/5/04 11:36 AM Page 82


Purchase price: As a rule of thumb, the price should not go below a 8.5cap rate. Since it may or may not be the final purchase price, it ’s bestto start at about 80 percent of the asking price. Always leave roomfor further negotiations.Down payment: Keep the down payment as low as possible. Notice Ididn’t say “cash” down payment. There are assets other than cashthat can be used as a down payment. (Refer to Chapter 9 on negoti-ations for additional sources.) Remember, the more cash invested ina project, the more it has to appreciate to maintain the same rate ofreturn. Consider using a part or all of the down payment for repairs

7. Seller warrants that at the close of escrow all plumbing, heating, cooling,electrical, appliance, and mechanical apparatus to be in working order, androof(s) to be in proper repair and free from leaks.

8. Seller is not aware of any structural defects or adverse geological and/orenvironmental conditions affecting the property.

9. Evidence of tit le is to be in the form of an owner ’s ALTA (American LandTitle Association) policy of tit le insurance.

10. The undersigned agree that any unresolved disputes will be submit ted toeither the American Arbitration Association or the Judicial Arbitration andMediation Service for binding arbitration.

FOR SELLERS: It is understood that Buyer is purchasing and Seller is sell-ing subject complex at a minimum scheduled gross income of $ peryear (or greater), as if the complex were 100 percent occupied.

ESCROW PERIOD: 60 days or sooner by mutual consent. Escrow to openwithout any contingencies.

COMMISSION: Buyer is a licensed Real Estate Broker. This of fer includesa percent commission to Realty Co.

This constitutes an offer to purchase the described property. Unless acceptanceis signed by the Seller and delivered in person or by mail to the address belowwithin 10 (ten) working days, this of fer shall be deemed revoked. Buyer acknowl-edges receipt of a copy hereof:

SELLER: BUYER: date date

Figure 7.1 Continued

c07.qxd 4/5/04 11:36 AM Page 83


rather than toward the selling price. It’ll give you more leverageand provide the seller with additional security if he assists in thefinancing.Deposit: Send a deposit check of approximately 1 percent of the offerprice with your offering package. On the back of the check write,“Not to be deposited until all parties have signed escrow instruc-tions.” This will prevent your check from being deposited before con-tingencies have been removed. Deposits placed in escrow usually geteaten up with fees for a myriad of trivial matters. You can be assuredthat this will happen, even if the deal doesn’t go through. The depositcheck must remain uncashed until escrow instructions have beensigned and contingencies have been removed.Financing: The financing package shown in the sample offer to pur-chase provides adequate leverage and monthly mortgage paymentsdesigned to create cash flow plus the maximum tax savings. Sellersmay not want to leave the existing mortgages in place. Make the ini-tial proposal anyway, especially if existing rates are below market.You won’t know what the seller will accept unless you try.

It’s difficult to get financing in a weak economy. Try to keep theexisting loans. Additional costs associated with getting new financ-ing such as points, appraisal fees, and escrow charges are expensive.Be absolutely certain, however, that the existing financing is less ex-pensive. The mortgage markets can be volatile. To save money, it ’s toyour advantage to keep abreast.

By leaving existing financing in place, the loan qualification pro-cess is eliminated, saving you additional time and expense. Also,you will gain control of more property by not having to pledge yourassets as security for obtaining new loans.

Never forget this basic rule: Use as little cash as possible to con-trol as much property as possible whenever possible. Try to get theseller to accrue as much of the monthly payments as you can. Whenaccruing all or a portion of the monthly mortgage payment, currentcash requirements are reduced. Based on the sample offer, interest isscheduled to be paid when rents are projected to increase.

Have the seller take back the note for a minimum of two yearspast the date you either plan to sell or refinance the property. Thisgives you breathing room. Also notice in the sample offer that theseller is asked to take back an assumable loan. If the property is soldbefore the note comes due, the new buyer won’t have any problemswith the assumption. It can be assumed without qualification orpaying nay additional costs. This important clause makes your prop-erty more marketable when it comes time to sell.

c07.qxd 4/5/04 11:36 AM Page 84


Remember, more cash equates to less leverage. Less leverage re-sults in fewer assets under your control. Fewer assets reduce yourpotential profits.

Item 1. If the property doesn’t pass your inspection, this provisiongives you the opportunity to cancel the contract. It ’s sometimes re-ferred to as the escape clause and details contingencies:

• Title report: You need to approve the title report. It is best to haveyour attorney review it. Your attorney should be able to tell you ifthere is anything that would adversely affect the property. He orshe must be able to comment on each item in the report and how itaffects your transaction. Make sure you get the attorney’s inter-pretations and recommendations in writing.

• Books and records: Have your accountant examine the books andrecords for at least a minimum of three years. Five years is prefer-able. The accountant should be able to report, in writing, on the in-come and expense trends and to compute ratios. Records mustreflect actual figures not estimates. All figures should be com-pared to actual tax returns, and any differences must be explained.Also, make a comparison with those published by local propertymanagement organizations and/or the Institute of Real EstateManagement (IREM) for credibility.

• Physical inspections: Physical inspections must be done by qualifiedconsultants (see Chapter 4). To assure that tenants are properly no-tified of all inspections, work with your property manager. Insistthat all inspection reports be in writing and include data on localclimatic conditions affecting the property. Every unit must be in-spected. Do not, under any circumstances, exclude a single unit. Itwill come back to haunt you. Estimates of repair and/or replace-ment costs must be included in the report. Roof(s), plumbing, me-chanical, and electrical have to be inspected. Repair costs should beitemized separately from replacement costs. The “written report”is essential when negotiating and preparing budgets.

Try to obtain copies of earlier inspection reports from theseller. They can save you time and money and will prove invalu-able in disclosing any problem areas. If there have been previousroof inspections, it could mean they are in bad shape. These re-ports, compared to your own, will give you a clear understandingof the condition of the building.

• Loan documents: Loan documents should be read by an attorney.You must determining the following:

c07.qxd 4/5/04 11:36 AM Page 85


Is there a due-on-sale clause (can the loan be called up if the prop-erty is transferred)?Are there any balloon payments? When?What will the monthly payments be over the life of the loan? (Anaccountant can give you this information, also.)Do these payments change? When?Are there any restrictions in transferring the loan?Do the terms comply with local lending laws?

It’s difficult to read and interpret lengthy loan documents yourself. Itis best to have your real estate attorney do it and supply you with a writ-ten report. This report becomes your safeguard if disputes arise later.

Item 2. All inspection reports should be approved in writing within10 days of receipt thereof. Written approval or rejection should besent to the escrow company and a signed receipt of delivery should beobtained. The seller is responsible for getting the information to youas quickly as possible. If you don’t receive it on time, contact theseller. Remember that in a down market, time is on your side. Theseller does not benefit from delays. However, both parties should becooperative. Be careful dealing with partnerships. Managing generalpartners may want you to remove all contingencies before getting the limited partners’ approval to sell. Don’t do it under any circum-stances! You’re leaving the door open for the seller to back out of the deal.

The seller must pay for this report and any work to be done if thereport from a licensed pest control operator provision is accepted. Ifthe property has to be tented and accommodations have to be madefor the tenants, it is the seller’s responsibility to pay.

The termite provision is especially important when applying for newloans or assuming existing ones. Lenders do not like to lend unless thebuilding has a clean bill of health from a qualified termite company.

Item 3. When forming a group to purchase property, this provisionallows you to transfer your position in the contract to other entities. Italso gives you a simple way to determine the current market value ofthe apartment complex. Here’s how it works. While under contract, ad-vertise the property for sale. Place your advertisement in a newspaperwith a large circulation (Wall Street Journal) on the day that real estateadvertisements are run. The amount and kind of activity generated isan indication of demand, hence value.

c07.qxd 4/5/04 11:36 AM Page 86


The advertisement may generate offers to buy. If you decide to sellyour position in the contract, this proviso gives you that right. Manyfortunes have been made using this technique without risking a dime.

You may also want to sell because a more desirable property is nowavailable. With this assignment provision it can be done. Having theflexibility to transfer ownership interests increases the likelihood ofsuccess.

If you locate a buyer for the property while under contract and, as areal estate licensee, you want to limit your involvement, simply intro-duce the buyer to the seller, using the sample agreement of introduc-tion (Figure 7.2).

AGREEMENT OF INTRODUCTION

I hereby employ you as a Broker for the period beginning , andending at midnight on , called the listing period for the purchaseof a certain real property described as follows:

(Property address)Broker ’s only obligation under this agreement is to introduce me to the

Seller and I shall be solely responsible for all due diligence and for negotiatingthe price and terms for purchase of the property.

I agree to pay Broker as a commission percent of the selling price, if,during the listing period or any extension of it, I or any affiliate purchases theproperty, or if I, in a capacity as broker, procure a Buyer on any terms accept-able to Seller. Thecommission shall be payable on the close of escrow or on failure to close if fail-ure is due to my default or lack of good faith.

If I have not entered into a contract to purchase the property within days from the execution of this agreement, Broker shall be allowed to marketthe property to others without terminating my obligation to pay Broker a com-mission pursuant to this agreement.

If, within days af ter the termination of the listing period or any exten-sion of it, I or an affiliate acquire the property or I procure a Buyer for the prop-erty, Broker shall be entit led to a commission in the amount and on termsspecified in this agreement.

Buyer Date

Broker Date

Figure 7.2 Sample agreement of introduction letter.

c07.qxd 4/5/04 11:36 AM Page 87


Concurrently, send the sample letter (Figure 7.3) to the seller havingthe seller acknowledge and consent to your acting as an agent for thenew buyer.

Item 4. During the escrow period, it ’s important to maintain as muchcontrol over operations as possible. A seller could make long-term com-mitments to either tenants or vendors that might adversely affect yourinvestment. This provision will prevent it from occurring.

With the cooperation of the seller, tenant/owner personality con-flicts can be reduced by having the seller implement rent increases be-fore escrow closes. Tenants will probably be more receptive to havingthe existing owner institute increases than you. Negatives associatedwith such a move should be avoided whenever possible.

Date

Dear Seller:

RE: Notice of agency and commission

This let ter will confirm that I called you and disclosed that I had enteredinto a contract with (buyer) to act as their agent in the purchase of your prop-erty located at (location). As you know, I am a licensed real estate agent. Bythis let ter it is my intention to put you on notice that:

1. I shall act solely as the buyer ’s agent.2. I will receive a commission from the buyer if this transaction is consum-

mated.

Please sign the acknowledgment below and return a copy to me for myfiles. If you do, in fact, object, please so state in writing within 5 days.

I look forward to working with you in the future.

Sincerely,

Broker

I hereby acknowledge and consent to (broker) acting in the proposed trans-action solely as agent and broker for (buyer). I further agree that (broker) mayreceive a real estate commission from the buyer and that I will have no suchfinancial obligation.

Seller Date

Figure 7.3 Sample letter of acceptance.

c07.qxd 4/5/04 11:36 AM Page 88


Item 5. The purpose of this provision is to make sure the seller hasthe authority to transfer title. It could be that the seller doesn’t, andyou will want to know immediately. The seller may need approvalfrom a trustee, partners, or an attorney. To avoid spinning yourwheels, be sure you’re working with the person(s) who can legallysign all documents.

Governmental and judicial agencies can cloud title. This provisionputs the seller on notice that any pending complications are to be dis-closed. A preliminary title report might now show these potential snags.Having the seller’s warrant will help if disputes arise. In areas wherethere are high ratios of renters to owners, local governments might beconsidering rent controls. If there is anything brewing, you must bemade aware of them before escrow closes.

Item 6. This provision allows you to extend the escrow closing periodby depositing additional funds in escrow. Sometimes totally unex-pected things can come up that delay a closing. If escrow cannot closeon a specific day, this clause gives you the ability to extend it.

Theoretically, with this provision you can literally keep makingthese deposits of principal and extend the closing until the apartmentbuilding is paid in full.

Item 7. It’s important to have express warranties. They are guarantees,specific as to the contract. Express warranties can extend the time of im-plied warranties. They can provide protection in areas not normally cov-ered by implied warranties such as the quality of the work done and thelife of certain fixtures. In addition, express warranties can include reme-dies for losses not normally found in implied warranties.

What are implied warranties? Implied warranties are those for whichthe law will hold the builder or seller accountable even though no prom-ises are written in the contract. Implied warranties must be honoredsince they can seldom be limited or eliminated in a contract.

There are three implied warranties in real estate:

1. The property purchased is constructed in good and skillfulmanner.

2. The property is habitable.3. The property will be reasonably fit for the intended purpose.

Implied warranties are subjective and can be interpreted loosely.The more specific the warranty the more enforceable it becomes.

c07.qxd 4/5/04 11:36 AM Page 89


Item 8. The purpose of this provision is to make the warranty morespecific. Potential problems usually don’t appear in title reports. It isbest to protect yourself in case something comes up later. For example,adverse soil conditions, flood control areas, or a toxic waste dump canput a damper on any improvements or additions to your apartmentcomplex. This provision puts the seller on notice that any and all knowl-edge possessed in this area must be disclosed.

Item 9. Coverage under the American Land Title Association (ALTA)policy is designed to protect the buyer. It covers legal fees for defend-ing title and defects in the title prior to purchase. In some areas, youcan obtain additional insurance for easements and items not shown onthe title report.

Title company sales representatives are very helpful in answeringquestions regarding title insurance. They also aid in obtaining prelim-inary title reports and property profiles (ownership and legal data) onvarious properties for you. The service that they provide gives them anopportunity to generate goodwill, and hopefully, you will purchasetitle insurance from their company.

Item 10. The benefits of arbitration far exceed those of litigation. Thisprovision nails down the procedure for resolving disputes. A judge oncetold me, “The most equitable resolution of any disagreement occurswhen both parties walk away unhappy!”

For sellers: This statement lets the seller know that your computationsare based on the seller’s gross income figures. Gross income is a veryimportant component in determining selling price. Making the selleraware of it, up front, will help in negotiations if gross income cannotbe substantiated.Escrow period: The escrow opening date should be tied to the re-moval of contingencies. For example, if escrow is to open after allcontingencies have been removed, don’t open sooner. Sellers usuallywant the escrow to open immediately. This provision in the sampleoffer gives them that additional motivation to get all the paperworkin on time. Don’t forget, opening escrow without contingencies isless cumbersome and costly. Prematurely opening escrow fre-quently results in numerous changes. Don’t cause extra headachesand expense by rushing into escrow. Keep it simple.Commission: Real estate licensees may only want to receive their com-missions in cash. However, if the buyer’s cash is limited, it may be a

c07.qxd 4/5/04 11:36 AM Page 90


good idea to take your commissions in paper (a note) to make thedeal work.

If you’re a real estate agent and you’re buying the property, con-sider reducing both the price and down payment in lieu of com-missions. You can save money on your taxes by not having to reportany income.

If commissions have to be paid, reducing the down payment andselling price accordingly, guarantees the buyer will be paying less.Remember, the savings on commissions should benefit both parties.Whether you agree to split the savings on commissions or not, al-ways look to the internal rate of return, irrespective of commissions,when making investment decisions.Closing paragraph: Don’t give the seller too much time to think aboutyour offer. A time limit of approximately 10 working days from thedate of the offer should be sufficient. Technically, without it a re-sponse could be made at any time and still be valid. Legally, if a re-sponse is not made in the time allotted, a binding contract does notexist. However, if the seller answers after the deadline and you ac-cept the counteroffer within the allotted response time, the contractthen becomes binding.

Make Sure Your Contract Is Legally Binding

To be assured that a legally binding contract is in effect, proper procedures must be followed. Documents must be signed and deliv-ered on a timely basis to the right parties. Timely delivery is very im-portant. Without it you do not have an enforceable contract. To beassured that delivery is made on time, a signed receipt of delivery isrecommended.

A SUREFIRE COVERING LETTER When sending an offer to pur-chase, accompany it with the sample letter (Figure 7.4) and a check forapproximately 1 percent of the offer price. Also include the followinginformation:

1. Your financial and business qualifications2. Your after-tax internal rate of return requirements (don’t dis-

close what it is)3. Your knowledge of current market values4. Financing package limitations

c07.qxd 4/5/04 11:36 AM Page 91


Time is of the essence in getting a counteroffer. The seller cannot siton your offer waiting for others so that one can be played off the other.Let the seller know you’re making offers on other properties.

WHEN DEALING WITH SELLERS, ONLYGO AROUND ONCE

Depending on very unusual circumstance, always make it a rule neverto write a second offer on the same property without first receivinga written counteroffer. Sellers will say, “I can’t accept your offer, it ’stoo low. Why don’t you just write another one.” Your reply should be,“Since I spent a good deal of time and money submitting this offer, Iwould appreciate the professional courtesy of having you write a coun-teroffer.” If the seller refuses, go on to the next deal. It has been our ex-perience that the few times we’ve submitted a second offer without firstreceiving a written counteroffer, we never heard from the seller again.

If the seller counters and it is not acceptable, try some preliminarynegotiations, based on the following market conditions:

Figure 7.4 Sample offer letter.

Your address

Date

Dear (seller or agent):

RE: (property address)Enclosed please find our of fer to purchase, our track record (or your

financial statements), and deposit check.Af ter completing an analysis and drive-by inspection, we believe the

enclosed price and terms are reflective of current market values in the area.Based on our af ter-tax internal rate of return requirement, we are limited to

the proposed financing package.We would appreciate hearing from you as soon as possible due to our

relatively short time frame. If you have any questions, please call.

Sincerely yours,

(Your name)

c07.qxd 4/5/04 11:36 AM Page 92

A UNIQUE ACCEPTANCE LETTER 93

Weak Buyers Market

If there are a number of buyers bottom fishing, quickly submit an offerthat will tie up the property. Initiate further negotiations, if necessary,after completing all inspections.

Strong Buyers Market

Time is on your side. Wait until the seller calls before making yournext move. If the seller doesn’t call, wait and make contact again inabout three weeks. Maybe the seller will be more receptive to negoti-ating then.

We have purchased property where offers and counteroffers haveflown back and forth at least a dozen times. You’ll discover that in downor weak markets time is really on the buyer’s side. Never be overly anx-ious to accommodate the seller’s time schedule.

A UNIQUE ACCEPTANCE LETTER THAT EFFECTIVELY TIES UP PROPERTY

When an acceptable offer is received, call the seller to advise thatyou’ve accepted it. Immediately mail, receipt requested, an originallysigned copy with an acceptance letter (Figure 7.5). Be sure the date ofacceptance is within the allowable time. A late acceptance makes thecontract voidable.

Critical Documents for Due Diligence

There are many critical pieces of information enumerated in the sam-ple acceptance letter (Figure 7.5) that are needed to perform an accept-able due diligence.

Copies of tax returns tend to be less creative than in-house incomeand expense statements. It’s always good practice to find out where thedifferences lie and why. For comparison, use the information on the set-up sheet to verify inspection reports, rent rolls, and financial statements.

Try to obtain information on items not covered in the title reports,such as lawsuits, pending rent control ordinances, governmental-assistedrent programs, and so forth.

Verify the size of the units by looking at floor plans. Building inspec-tors can give more accurate estimates of repairs and replacement costswith a set of floor plans.

c07.qxd 4/5/04 11:36 AM Page 93

94

Your address

Date

CERTIFIED MAIL

Dear (seller or agent):

RE: (property address)Enclosed please find acceptance of the offer (or counteroffer) dated

.To proceed rapidly, please send us copies of the following information

regarding the subject property:

1. Last five (5) years year-end financial statements and tax returns2. Title report3. Current inspection reports4. Current appraisals5. Current rent roll6. Current financial statements7. All existing loan documents8. Litigation (existing and pending)9. Floor plans

10. Sales comparables11. Demographics12. Local business conditions13. Interior and exterior pictures14. Name, address, and telephone number of property manager15. Name, address, and telephone numbers of vendors16. Last 12-months utility bills17. All service contracts18. Insurance policies19. List of all personal property20. Current and last two years tax bill

Your cooperation in supplying this information as soon as possible will begreatly appreciated.

Sincerely yours,

(Your name)

Figure 7.5 Sample letter of acceptance.

c07.qxd 4/5/04 11:36 AM Page 94

SUMMARY 95

Whenever possible try to obtain as many photographs as you can ofboth the interior and exterior of the building. These will help clarifymany questions, especially if you haven’t seen the building.

Any information that can be provided directly by the seller will saveyou time and money by not having to obtain it from other sources.

SUMMARY

If I had to answer, “What is the most important thing to remember inthis chapter?” I would say, “Always get it in writing.” Write as many of-fers as you possibly can, but don’t lose credibility. If too many offers arereceived from you by the same person or company, your ability to per-form might be questioned. Be selective and know the parties involved.

Make every attempt to get a signed counteroffer. In doing so, theproperty will be under your control. You will have the time you need tocomplete your due diligence and to negotiate further, if necessary.

The only way to get experience is to get out there and do it. You maymake a few mistakes, but you’ll learn in the process. The most impor-tant thing to remember is to keep trying. You’ll improve each time,and you’ll find yourself securely on your way to becoming financiallyindependent.

c07.qxd 4/5/04 11:36 AM Page 95

c07.qxd 4/5/04 11:36 AM Page 96

97

8Highly EffectiveTechniques forAnalyzing Properties

Only after the property is under contract should you prepare a compre-hensive analysis, as shown in this chapter. Don’t waste time and moneybefore you legally control the apartment building.

THE KEY FIGURE IN EVALUATING INVESTMENTS

The key figure is the internal rate of return (IRR) after taxes. By com-paring this figure with the IRRs from other investments, you will beable to determine the best investment for you.

It is critical to understand why the IRR is important when analyzingproperty. The IRR shows the time value of money, and it reflects cashflows based on present values. Return on investments, in terms of pur-chasing power, might actually be less, depending on how the cost of liv-ing has changed. Knowing the IRR will help to further quantify yourinvestment opportunities.

Your analysis should be based on two types of returns, growth rateand replacement costs. Growth rate projections are based on historical

98 HIGHLY EFFECTIVE TECHNIQUES

trends. An analysis performed using this rate will give you a con-servative IRR. An aggressive IRR is obtained by projecting a futureselling price based on future replacement costs. Use both when analyz-ing apartment buildings. Knowing both will give you an edge whennegotiating.

What you should be looking for is steep growth. Buy apartmentcomplexes below the cost of replacement. Sell them when values are atleast equal to or greater than replacement costs. This is how to be-come wealthy!

A SOUND DOWN-MARKET STRATEGY

In a down market, your strategy is to buy as far below current replace-ment cost as possible. To determine the current replacement cost, con-sult local building associations or your local library for the Marshall &Swift Valuation Service (M&SVS). M&SVS provides information on theconstruction costs of different types of apartment buildings through-out the United States. Figures 8.1, 8.2, and 8.3 (pp. 100–105) show howcosts differ based on style for three types of apartment buildings.Local square footage costs can be calculated using the conversion chartapplicable to each area.

ANALYZING PROPERTY

The methods to analyze property depend on the availability of infor-mation. They are as follows:

• Qualified appraisers• Comparable sales data or “comps”• Gross multiplier approach• Capitalization rate method• Essentials of property analysis software

We prefer using a specially designed computer program in conjunc-tion with input from consultants and comparable sales data. Since thefinal decision rests with us, we want to be absolutely certain of oursources.

Qualified Appraisers

Appraisers use three appraisal techniques to establish the current mar-ket value of apartments. They are the (1) cost, (2) income, and (3) marketdata approaches. The cost approach establishes market value based on

ANALYZING PROPERTY 99

what it would cost to replace a reasonable facsimile. The income ap-proach is designed to calculate the market value based on the expectedfuture income. And the market data approach uses information gath-ered from recent comparable sales to determine value.

The appraiser considers all three methods when making a final de-termination as to current market value.

Comparable Sales Data or “Comps”

In a weak market, it is difficult to use comparable sales data to deter-mine market value. Sales figures may not be available or may be stale be-cause properties aren’t moving. Prices, under these circumstances,usually have no bearing on current market conditions. At best, compara-bles will give an indication of trends.

A sample of comparable sales information from the CoStar Group(Figures 8.4 through 8.8, pp. 106–120) shows how the information ispresented. Local real estate boards can be of further assistance.

Gross Multiplier Approach

The gross multiplier approach is the ratio between the gross rents andthe selling price. By comparing gross multiples of other properties in thesame general area, a rule-of-thumb determination of market values canbe made.

Capitalization Rate Method

The capitalization rate is the ratio between the net income and the sell-ing price. This rate can also be compared to those of other buildings inthe same neighborhood. Capitalization rates should be adjusted to re-flect the following:

• Liquidity: How fast can you get your money out?• Risk factors: What is the degree of safety?• Tax benefits: How much money will you save on taxes and when?• Ability to borrow money: Is it easy to get loans on the property?• Degree of management activity: How much time do you have to put

into managing your investment?• Expectation of appreciation: What is the potential of this property?

We generally don’t purchase apartment buildings with a capital-ization rate under 8.5 percent. However, depending on the weight ofthese factors, we would consider a lower capitalization rate. Adverse

Figure 8.1 Multiple residences (fair quality). Reprinted by permission ofMarshall & Swift.

Figure 8.2 Multiple residences (average quality). Reprinted by permissionof Marshall & Swift.

Figure 8.3 Multiple residences (good quality). Reprinted by permission ofMarshall & Swift.

106

Figure 8.4 Comparable sales information for Atlanta apartment building.Source: Copyright© 1999–2002 CoStar Realty Information, Inc. All rightsreserved. Information obtained from sources deemed reliable but not guar-anteed. Phone: (800) 204-5960.

107


108


109

Figure 8.5 Comparable sales information for Tucson apartment building.Source: Copyright© 1999–2002 CoStar Realty Information, Inc. All rightsreserved. Information obtained from sources deemed reliable but not guar-anteed. Phone: (800) 204-5960.

110

Figure 8.5 Contnued

111


112

Figure 8.6 Comparable sales information for Miami apartment building.Source: Copyright© 1999–2002 CoStar Realty Information, Inc. All rightsreserved. Information obtained from sources deemed reliable but not guar-anteed. Phone: (800) 204-5960.

113


114


115

Figure 8.7 Comparable sales information for Glendale apartment building.Source: Copyright© 1999–2002 CoStar Realty Information, Inc. All rightsreserved. Information obtained from sources deemed reliable but not guar-anteed. Phone: (800) 204-5960.

116


117


118

Figure 8.8 Comparable sales information for Miami apartment building.Source: Copyright© 1999–2002 CoStar Realty Information, Inc. All rightsreserved. Information obtained from sources deemed reliable but not guar-anteed. Phone: (800) 204-5960.

119



conditions cause the capitalization rate to be adjusted higher; favorableconditions cause it to be lowered.

Essentials of Property Analysis Software

Choose a computer program that fits your needs. We prefer using theprogram created by The Center for Real Estate Studies (for more infor-mation on the software package, see page 226) which is specifically de-signed to analyze investments in apartment buildings. You should selectsoftware capable of providing the following features:


ANALYZING PROPERTY 121

• Projections and analysis of cash flows and tax benefits using theIREM format

• Maximum forecasting flexibility• After-tax IRR• User friendly

A computer program that has these features makes it easier to ana-lyze properties. If the data is accurate, your reports will supply you withthe necessary facts to make the right investment decisions. Figures 8.9,8.10, and 8.11 illustrate the kind of analysis used to evaluate apartmentbuildings.

When inputting data, numerous assumptions must be made. There’san expression that communicates the importance of inputting gooddata. If data submitted to computer operations came back stamped“verified,” it meant it was accepted. Reports stamped GIGO meant theopposite! GIGO stands for “garbage in garbage out.” The same applies

Phoenix

Percentof GPI $/SQFT

Income:Gross possible rents $115,332.24 96.00 5.77Vacancy/rent loss −16,699.14 13.90 .83Other income 4,805.50 4.00 .24

Total Collections $103,438.60 86.10 5.17

Expenses:Administrative $ 7,783.00 6.48 .39Operating 9,244.00 7.69 .46Maintenance 6,613.00 5.50 .33Tax / insurance 7,965.00 6.63 .40Recreational/amenities 365.78 .30 .02Other payroll 4,567.00 3.80 .23

Total Operating Expenses $ 36,537.78 30.40 1.83

Net Operating Income $ 66,900.82 55.69 3.35Debt Service −47,997.10 39.95 2.40

Cash Flow af ter Debt Service $ 18,903.72 15.74 .95

Cash Effects of:Tax on Net Operating Income $−20,739.25 17.26 1.04Tax on Interest Expense 18,007.67 14.99 .90Tax on Depreciation Expense 5,202.96 4.33 .26

Net Cash Flow af ter Taxes $ 21,375.10 17.79 1.07

Figure 8.9 Sample analysis—Phoenix.


to investment data. If the information inputted is garbage, your outputwill be the same.

The computer program should be designed to give an IRR based onspecific assumptions. Confer with your consultants to assist you in mak-ing these assumptions. For example, estimates of tax rates and deprecia-tion should be made with the help of your tax advisor. When speculatingon general business conditions in the area, your property manager orreal estate broker should be consulted for advice. These professionalsmust be able to provide you with the data needed to make the right as-sumptions.

THE INTERNAL RATE OF RETURN TO AIM FOR

The IRR should reflect the degree of risk you’re willing to take. Themore risky an investment, the higher the IRR. If you’re purchasing anapartment building that has decreased in value only because of tem-porary market conditions, your degree of risk might be considered

Seattle

Percentof GPAI $/SQFT

Income:Gross possible rents $ 273,777.41 96.40 9.11Vacancy/rent loss −17,324.09 6.10 .58Other income 10,224.06 3.60 .34

Total Collections $ 266,677.38 93.90 8.88Expenses:

Administrative $ 24,241.00 8.54 .81Operating 21,527.00 7.58 .72Maintenance 12,729.00 4.48 .42Tax / insurance 22,837.00 8.04 .76Recreational/amenities 842.57 .30 .03Other payroll 11,419.00 4.02 .38



Cash Flow af ter Debt Service $ 57,088.84 20.10 1.90

Cash Effects of:Tax on Net Operating Income $ −53,655.36 18.89 1.79Tax on Interest Expense 43,518.52 15.32 1.45Tax on Depreciation Expense 12,573.83 4.43 .42


Figure 8.10 Sample analysis—Seattle.

REVENUE ASSUMPTIONS THAT MAKE SENSE 123

moderate. Conservative projections are computed using rental growthand vacancy rates, and they establish the lower limits of the IRR. IRRprojections based on replacement costs determine the higher limits ofthe IRR. Analyzing both rates of return allows you to assess the risksversus rewards relationship of each investment.

REVENUE ASSUMPTIONS THAT MAKE SENSE

Revenue assumptions play an important part of your analysis. In addi-tion to the information provided by consultants, check with local apart-ment rental firms. They are on top of current trends and demand. Leaseagreements should be verified to actual rents for each tenant. Userental applications to develop tenant profiles. Obtain a signed estoppelfrom each tenant attesting to the rent paid, occupancy dates, and de-posits. Rent raises don’t always occur on the first day of the month or inthe first month of the year. A careful review of rental agreements willassist in making accurate cash flow projections. Ideally, try to stagger

Boston

Percentof GPI $/SQFT

Income:Gross possible rents $ 283,227.42 99.40 8.78Vacancy/rent loss −14,246.85 5.00 .44Other income 1,709.62 .60 .05

Total Collections $ 270,690.19 95.00 8.39Expenses:

Administrative $ 11,937.00 4.20 .37Operating 35,997.00 12.60 1.12Maintenance 15,824.00 5.60 .49Tax / insurance 19,525.00 6.90 .61Recreational/amenities 3,423.52 1.20 .11Other payroll 5,830.00 2.00 .18



Cash Flow af ter Debt Service 38,162.14 13.40 1.18

Cash Effects of:Tax on Net Operating Income $ −55,227.64 19.40 1.71Tax on Interest Expense 52,522.38 18.40 1.63Tax on Depreciation Expense 15,175.31 5.30 .47


Figure 8.11 Sample analysis—Boston.

124

Life Expectancy Guidelines

Replaceable Components

When capitalizing the income of investment properties, it is necessary to include in the expensesan annual reserve for the replacement of various components which have a shorter life than thebuilding as a whole (see Section 81). To estimate the annual reserve for replacement of a compo-nent, divide the estimated years of life into the total cost of the component. The following guidegives the most typical of such items and an estimated life under standard applications in years foreach, sub-divided by quality. Individual component lives can have a wide range depending on theloads and conditions placed on them, the method of installation, and appropriate maintenanceand warranties. Lives may be shortened under severe requirements due to heavy wear, corrosivecontact and/or atmospheric conditions, etc. or lengthened under very light usage, mild circum-stances, protective coatings, etc. Costs for the various components may be selected from appro-priate tables throughout the manual. The allocation of a component cost over its expected servicelife can also be used in establishing reserves for condominium or owner ’s association budgets orsinking funds, etc. and in the evaluation of life-cycle costing for use in the component selection ordesign alternative process, for financial planning, energy analysis or audits, etc.

Component Low Average Good Excellent

AppliancesMajor appliances, residential 10 12 15 18Garbage disposers, washing machines 6 8 10 12Radio-intercom, paging systems 12 15 19 24Telephone systems 9 10 11 12Vacuum cleaning system 12 13 15 17

Floor CoveringAccess (Computer) floor 10 12 15 18Carpet and pad 4 5 7 10Carpet tiles 5 6 8 10Ceramic or quarry tile or pavers 25 30 34 40Indoor-outdoor carpet 3 5 7 10Vinyl composition tile or sheet 7 10 14 19Vinyl or rubber tile or sheet 12 15 19 24Wood flooring 21 25 30 35

Miscellaneous InteriorAcoustical ceiling tiles or panels 8 10 12 15Built-in lockers, mail boxes, etc. 12 15 20 25Partitions, demountable 16 20 25 30

folding 8 10 12 15Drapery 6 8 10 12Paint 3 5 7 10Wallpaper 7 10 13 18Wood doors 18 20 22 25

Conveying SystemsElevators and escalators 18 20 23 26Pneumatic tube system 12 13 15 17

Heating, Cooling, and VentilatingForced air heat 12 14 17 20Heating and combined cooling plants 12 15 20 25Package heating and cooling 5 8 13 20Refrigerated air conditioning, central 10 13 16 20Package refrigeration 5 7 10 15Refrigerated coolers, window 7 9 11 14Solar heating systems 5 7 10 15Unit heaters 8 10 14 18Wall or floor furnaces 10 13 16 20

Figure 8.12 Life expectancy guidelines. Source: Marshall Valuation Service© 1990, Marshall & Swift. Printed in U.S.A.

125

Component Low Average Good Excellent

Evaporative coolers 5 6 8 10Exhaust and ventilating fans 6 9 12 18

For detailed components, see Section 53.Storage tanks, see Section 61.

Plumbing and ElectricalPlumbing fixtures 17 20 25 30Faucets and valves 8 10 13 16Water heaters, residential 2 4 7 12commercial 8 11 15 20

Light fixtures, residential 15 20 26 35Light fixtures, commercial 7 10 14 20Emergency generators 22 25 27 30Sprinkler and fire protection systems 20 23 26 30smoke and heat detectors 13 15 17 20

Miscellaneous pumps, motors, controls 3 4 7 10

RoofingBuilt-up tar and gravel 10 13 16 20Composition shingles 12 16 22 30Elastomeric 12 15 20 25Metal 13 20 30 45Wood shakes 20 24 29 35Wood shingles 16 20 24 30Tile, concrete or clay 30 36 42 50Slate or copper 50 60

MiscellaneousStore fronts 18 20 22 25Doors, automatic 7 10 14 20overhead 8 10 12 15

Storm windows 8 10 12 14

Site ImprovementsFlag pole 16 20 25 30Fencing, chain link 13 15 17 20

masonry walls 20 25 30 35wood 6 8 10 12wind screens 4 5 6 7

Landscaping, decorative shrubs, trees, etc. 7 10 14 20Outdoor lighting fixtures 10 13 16 20Outdoor furniture 3 5 7 10Parking lot bumpers 3 4 5 7Paving, asphalt 5 8 11 17

concrete 10 13 16 20gravel 3 5 7 10

Snow melting systems 8 10 12 14Sprinklers, galvanized pipe 10 14 18 25

plastic pipe 15 18 22 28controllers and pumping systems 8 9 11 13

Stairway and decks, wood 7 9 12 15cement composition 12 15 20 25

Swimming pool, residential 15 18 21 25commercial 10 15 20 30mechanical equipment 4 5 6 7solar equipment 7 10 14 20

Tennis court 18 20 22 25asphalt /colored concrete resur facing 3 4 5 7nets 1 2 2 3

Underground sewer & water lines 22 25 28 32



individual rent raises throughout the year. It is less disturbing to theentire complex.

Vacancies vary in seasonal locations like college towns and resortareas. Make provisions for these fluctuations in cash flow projections.Don’t assume income will be received evenly month-to-month and year-to-year. Projections based on research will result in a more accurate IRR.

ANALYZE EXPENSES CORRECTLY

When analyzing expenses, refer to the property inspection report. Itshould detail, by projected date the costs, repairs and replacements foreach unit and the entire building. Using a comprehensive computer pro-gram will produce accurate operating budgets.

Mechanical equipment such as water heaters, dishwashers, garbagedisposals, and pool equipment, for example, have estimated life spans(see Figure 8.12, pp. 124–125). Major repairs and replacements onroofs, plumbing, decking, and cement should be detailed by estimatedcosts and the dates work is to be started and completed.

As with income, expenses do not occur evenly throughout the year.For example, in cold climates, utility bills are higher in the winterthan in the summer. With grounds and pool maintenance, it is justthe opposite.

Expense figures should be compared with those published by theIREM. All sizable discrepancies must be explained.

Do not make flat rate projections. Don’t apply inflation rates acrossthe board. Projections should be made on an item-by-item basis usingthe best information available. For example, if the inflation rate of 5 per-cent is used in one year, don’t use it again unless it applies. Actualsshould be used whenever possible.

USE THE FEEL-AND-TOUCH ANALYSIS

As part of the analysis, absolutely nothing beats the feel-and-touch ap-proach. A physical inspection of the property and the neighborhood willconfirm your consultant’s reports. Critical words like good, bad, best,worst, bright, dull, a lot, and a little are subjective. Make sure everyone’ssinging from the same hymn book when praises to your property arebeing sung!

Ask yourself the following questions when evaluating the area aspart of the physical inspection:

• Would you be willing to live or at least collect the rents in thisneighborhood?

SUMMARY 127

• What’s the graffiti index?• How does the landscaping of the other properties compare with

the one you’re considering?• Is there debris in the streets?• Are there cars on blocks?• Is it completely off the beaten path to major shopping and work

centers?• Is the community growing favorably in the direction of your

property?• Are transportation lines readily available?• Are schools and recreational facilities nearby?• What is the ratio of renter- to owner-occupied buildings?

The greater the rental population, the more transient the area be-comes and the greater possibility of it being left unkempt. The physicaltest will give you that personal viewpoint necessary to complete theanalysis.

Even in depressed markets you should look for properties in goodlocations. A cardinal rule is to buy the worst property in the best loca-tion, not the best property in the worst location. Buying the poorestproperty in a good location, at least gives you the opportunity to upgrade it. Whereas, upgrading an entire neighborhood could be dif-ficult, if not impossible. When in doubt, a drive through will help.Contact your local property management company or real estate li-censee for assistance.

SUMMARY

The various methods of analyzing property have been discussed in thischapter. Why perform these analyses? Simply to find out how the build-ing should be operating and what the anticipated profits should be.

When estimating profits, use the growth rate for the low or conser-vative end, and the projected replacement cost for the high end.

The internal rate of return is the key figure to use when evaluatingapartments. Comparing the IRRs of other investments will help youdetermine whether the rewards are worth the risks.

Knowing what to expect from computer software programs and howto input the data correctly will produce meaningful reports for intelli-gent decision making.

The best approach to analyze midsize apartment buildings is to use acombination of the evaluation methods discussed in this chapter. Doingyour own analysis, with the help of your consultants, gives you a betterunderstanding of your investment and its profit potential.

129

9How to Become anOutstanding Negotiator

When I first started buying and selling apartment buildings, I put anoffer in on an apartment building. I had my appointment set at 1:00P.M. and I had to wait until 3:00 before the seller would see me. So, Isat in the office for nearly two hours anxious to present my offer.When I finally did get into the seller’s office to present the offer, helooked at it and started laughing. He pulled a stack of offers about 3inches deep out of his lower left-hand desk drawer. He said, “You’rekidding. Get me another offer.” Right then and there I should haveasked for a counteroffer, but still being new at the game, I went backand rewrote another offer. Fortunately, I made money. Appreciationbailed me out!

About a year-and-a-half later, the same seller had another propertyfor sale. I presented the offer, but this time I made sure he was on time.When I presented the offer to him, he started laughing and again hereached in his lower left-hand drawer, pulling out a stack of offers andsaid, “You’re kidding. How can you offer me this; get me another offer.”And I said, “May I see them?” He started yanking the stack toward himand I yanked them toward me, I finally yanked them away from him and

c09.qxd 4/5/04 11:37 AM Page 129

130 HOW TO BECOME AN OUTSTANDING NEGOTIATOR

started looking at some of the offers. They were for other properties andsome of them were two or three years old. He was playing “real estatepoker.”

I sat down with him and said, “If you want to sell, we want to buy, Ihave offers on two other properties.” Actually, we didn’t have any. ButI was playing real estate poker, too. We negotiated. He got the price hewanted, and I got the terms I wanted. I made a substantial profit on itplus I also saved money on my taxes.

Why is the seller selling? Finding the answer will give you the negoti-ating edge. For the most part, being in a weak market is enough motiva-tion in itself. However, there are other circumstances beyond depressedmarket conditions that motivate owners to sell. Some of these circum-stances are as follows:

• Poor management: It’s possible that the owner is doing a terrible jobmanaging the property, and there might be more vacancies thannormal for the area. Maybe the building is run down and theseller just doesn’t want to put any more money into it. The sellercould be an absentee owner without a competent local propertymanagement company, or one that simply doesn’t know how todelegate.

• Personal tragedies: Death, divorce, bankruptcy, or illness couldforce the sale of a property. These are basically trauma situationsfor the seller. We’re not suggesting that you take advantage ofpeople in distress. You should certainly treat them fairly.

In personal tragedies, the seller usually wants cash—which isdiametrically opposed to your standard operational procedure.Your investment plan calls for leverage created, in part, by sellerfinancing. However, if the price is right, you can still maintainleverage by structuring the transaction with outside financing.You’ll probably be negotiating with a trustee, and the trustee’sprimary goal is to get as much cash as quickly as possible for thebeneficiaries. Be prepared to act quickly when working with per-sonal tragedy circumstances.

• Retirement: When some people retire, they want to pack it all in.They don’t want the problems of management, and collectingmonthly income hassles-free rates high on their priority list. Themotivational key is the monthly income check. If you can struc-ture your purchase to give the seller the required monthly check,you will have an excellent chance at the deal. Notice I said re-quired monthly check. Monthly payments can be in any amount.

c09.qxd 4/5/04 11:37 AM Page 130

THE MOST EFFECTIVE FINANCING STRATEGIES 131

However, you must arrange them to give you the maximum cashflow and tax write-offs.

• Taxes: Taxes are one of the most compelling motivations in real es-tate transactions. A seller might want to trade his or her buildingfor another piece of real estate to defer taxes. The seller mightwant your property or might have another property in mind. Ifyou’re able to accommodate the seller in a trade, you might be ableto gain advantages in other areas such as price and terms.

The seller might be amenable to selling on an installment basis withlittle or no money down and carry back accrued paper. This financingpackage ideally fits into your plans.

Whatever the seller’s motivation, be flexible enough to explore all av-enues of approach. Try to work and rework the transaction to suit every-one’s needs. Your success depends on finding the right motivation andthe degree of intensity. Don’t attempt to negotiate any real estate trans-actions unless everyone is motivated. Ideally, the more the other party ismotivated, the better it is for you.

THE MOST EFFECTIVE FINANCING STRATEGIES

There are various methods of financing your acquisition. Listed nextare three of the most effective strategies used to purchase and/orcontrol property. Also, I’ve included a few tips that will protect youwhen negotiating.

Take a Loan “Subject To” Rather Than Assuming It

Depending on mortgage costs, the best method of financing is “subjectto.” Assuming existing financing or obtaining a new loan requires qual-ification and additional costs. Taking the loan subject to avoids both.

Protecting Yourself When Using an All-Inclusive Trust Deed

Robert Bruss, the National Real Estate syndicated columnist, pointsout that in selling, owners should consider owner financing because ithelps them sell their property faster at a higher price. Generally thesale is conducted through an instrument called an all-inclusive trustdeed (AITD).

If the apartment complex can’t be purchased subject to or the presentmortgage cannot be assumed the next best method is a wrap-around loan, or

c09.qxd 4/5/04 11:37 AM Page 131


an AITD. A new note is created encompassing or wrapping the existingloans. Usually, one mortgage payment is made to the noteholder of theAITD, from which the noteholder, in turn, pays the underlying loans. Foryour protection, use an independent trustee to handle these payments.This method of financing should be reviewed by an experienced real es-tate attorney. Be careful! A due-on-sale clause provision in any one of theunderlying notes could cause them to accelerate, making the entire bal-ance immediately due and payable.

To benefit from any equity buildup on the underlying notes, the bor-rower should only be liable for current unpaid principal balances.

A Little Known Secret of the Lease Option

The benefits of lease options have been extolled by respected nationalsyndicated real estate columnist Robert Bruss as a way to make a lowinitial investment to lock in a firm selling price. This gives you the pos-sibility of making a highly leveraged transaction.

At times it’s better to negotiate a lease-option agreement to ini-tially finance your purchase, instead of using mortgages. The cost ofan option can be paid in installments. As long as there’s a balancedue, escrow remains open, allowing you to maintain control of theproperty.

Lease options, when used in conjunction with subleases, can gener-ate significant tax savings. They are based on the intent of the parties.Consult a competent tax advisor for additional help.

WHO BENEFITS FROM COMPOUNDING INTEREST

Because it costs more for the loan, borrowers should insist that interestaccrue on a simple, rather than a compounded, basis. Lenders, on theother hand, benefit from compounding because interest charged on in-terest increases their yield. Have you noticed when financial institu-tions advertise interest rates they show two figures, one represents theactual interest rate, the other the yield? The higher figure is attributa-ble to compounding.

AVOIDING DEFICIENCY JUDGMENTS

Loan contracts should not contain deficiency judgment provisions. A defi-ciency judgment occurs when proceeds are not sufficient to pay off ex-isting loans. For example, if property with an $800,000 mortgage is sold

c09.qxd 4/5/04 11:37 AM Page 132

STOPPING LATE MORTGAGE PAYMENTS 133

and the net proceeds are only $700,000, a lender legally can demand pay-ment of the $100,000 deficiency.

To avoid these kinds of situations, take the loans subject to. They are,in themselves, nonrecourse-no-deficiency loans. The holder of the notehas recourse only to the original borrower. On the other hand, whenyou assume a loan, you become liable for deficiencies. If your loan con-tains a deficiency judgment clause, have your attorney take it out.

DETERMINING THE COST OF YOUR LOAN

Borrowers sometimes get confused trying to calculate the cost of a loan.To sort things out, forget about the various loan packages available andfocus your attention on present values. If you concentrate on this figure,you will be able to find out which one is the least expensive.

Have either the lender or loan broker calculate the present value ofthe loan based on total actual dollars to be paid, including points, ap-praisal fees, escrow costs, and so forth. Comparisons made on this basisgive the true cost of a loan.

RESTRICTIVE COVENANTS

Restrictive covenants could hinder transferability and act as a road-block to selling your property. Restrictions on specific time limits in re-financing, releases on loans, and due-on-sale clauses, should be avoidedwhenever possible.

When buying an apartment complex that’s built on contiguous lots,try to obtain individual releases as each is paid off. You will have theflexibility to choose what lots you want to own free and clear withouthaving to pay the entire mortgage. A lot in default would not affect theunencumbered parcels.

STOPPING LATE MORTGAGE PAYMENTS

Late payment penalties should be spelled out in the loan. There aretwo methods of handling late penalties.

One is to include “due on the first, late on the tenth” of each month inthe contract. You’ll probably get your check closer to the tenth. The otheris to have the contract read: “due on the first, in default thereafter.”Legally, the property can be put in foreclosure if a payment is not paidon the first of the month. Foreclosure costs only have to be paid once(they are much higher than late penalties), and it won’t happen again.

c09.qxd 4/5/04 11:37 AM Page 133


Some states give automatic grace periods before payments are con-sidered late and foreclosure proceeding can begin. If in doubt, contactyour local real estate attorney.

ADJUSTING MORTGAGE PAYMENTS TOPRODUCE CASH FLOW

Mortgage payment can be negotiated to produce cash flow. Monthlypayments can be tied to fluctuations in income by either increasing ordecreasing the interest accruals. All mortgage payments don’t have tobe paid on the first day of each month. They can be paid annually orsemiannually, quarterly, or whatever is agreed upon.

If the seller doesn’t want to accrue interest, he or she might agree toamortize the loan over a longer period of time, possibly 40 or 50 years.Highly motivated sellers may even agree to monthly payments that aretied to cash flow. When operations produce cash, all or a portion of themortgage can be paid. If there’s no cash flow, then no payments aremade. Interest could either be waived or accrued. You’ll be surprised tofind just how agreeable motivated sellers can be.

GETTING THE IRS TO PAY FOR YOUR INVESTMENT

Within certain limitations, interest rates and payback periods can beadjusted as an offset to price. Buyers can get a higher interest expensededuction, and sellers get a higher interest rate on a short-term notethat will make it more salable.

Lowering the purchase price has a minimal effect on taxable incomebecause the depreciation deduction has been reduced as a result ofchanges in the tax laws. Discuss this complicated strategy with your taxadvisor before implementing.

WORKING WITH CONSTANT CHANGEAND LIMITATIONS

After the property is purchased, monitor all changes that may affectyour investment. Never be afraid to ask the holder of the note for betterterms. A refusal is the worse that can happen. Things change over time.Motivations change. People change. Always be cognizant of change. Youmight be able to negotiate a better deal.

Remember, you’re attempting to buy in distressed markets due pri-marily to overbuilding. If you’re working with the bank’s and savingsand loan’s real estate owned departments, keep in mind that they are

c09.qxd 4/5/04 11:37 AM Page 134

PRICE STRATEGIES THAT WORK 135

governed by stringent regulatory agencies. They have limitations onthe financing proposals they are able to accept. You might not be ableto accrue interest, but you may be allowed to extend the life of the loanor pay interest only.

ALWAYS THINK OF THE SALE WHEN BUYING

Always think about how you’re going to sell the property while negoti-ating its purchase. If you incorporate the following strategies, the build-ing will be easier to sell:

• Have the seller take back assumable financing free from any feesand loan qualification requirements.

• Avoid long-term laundry, pool, landscaping, and any other main-tenance service contracts. Since you don’t know what a subse-quent buyer’s plans might be, it ’s best to leave as many optionsopen as possible.

Always think in terms of “how this will benefit the next buyer”when negotiating the purchase.

PRICE STRATEGIES THAT WORK

In negotiating, always remember that price is inversely related to terms—the more you insist on your price, the less you will be able to insist onterms (loans). When making a concession on price for better terms,never forget its effect on the IRR. Buyers should always demand lowdown payments, below market interest rates, longer pay-back periods,and interest accruals.

By putting more cash down, in effect, giving up terms, you’re in abetter position to dictate price. Unless you’re stealing the building, oryou can resell it rapidly for a profit, go with the terms. You may run therisk of tying up leverageable assets for longer than may be necessary, ifyou don’t.

Figures Smart Investors Want to See

The asking price should be based on the actual net operating income(NOI) when calculating the capitalization rate—not estimates or projec-tions. If the NOI is lower than what’s represented on the set-up sheet,the selling price should be reduced or more favorable terms should begiven. Written reports from experts substantiating your figures, will

c09.qxd 4/5/04 11:37 AM Page 135


always strengthen your position. Incorporating these findings into yournegotiations will give you a winning hand when playing “poker” withthe seller.

Never Pay Taxes on Profits Again

The price can be negotiated based on a trade. If both parties want totrade their properties, equities can be adjusted for favorable tax advan-tages. As long as the transactions are done correctly, you will never haveto pay taxes on your profits again. Consult your real estate tax advisorfor more details.

Avoiding Mistakes When Negotiating

Don’t be fooled by the seller who says, “That’s why the price is what itis. I took into account all of those things.” To avoid making mistakeswhen negotiating, never lose track of the IRR. It should always be yourreference point. The seller has to prove that your computations arewrong, so just stick to your guns. You’ll do fine!

DOWN PAYMENT STRATEGIES THAT WORK

The preferred down payment strategy is leverage. However, you must berealistic using this approach. Unless you have information to the con-trary, start by offering 10 percent down, and it doesn’t have to be casheither. There are other valuable resources that can be used. Here are afew to consider:

• Create paper: Prepare a note and secure it with your house, busi-ness, or other property.

• Professional services: Create a contract for your services as a valu-able asset. Agree to repair the building as a down payment. Theseller’s equity will be more secure if you do.

• Assign income: Assign income from rents, commissions, profits,and future income. Judgments, inheritance, and lottery win-nings, for example, can also be given.

• Additional loans: Loans from family members, credit unions, realestate licensees, insurance policies, or certificates of deposits willwork.

• Partnership: You can reduce your cash outlay by having each mem-ber invest either cash or notes. The financial strength of a group ismore substantial than its individual members. Sellers are morelikely to accept unsecured paper when issued by a group.

c09.qxd 4/5/04 11:37 AM Page 136

WHEN THE BUYER WANTS YOU TO PAY FOR REPAIRS 137

• Other assets: Planes, cars, boats, accounts and notes receivable, an-imals, trade inventory, hobby and athletic equipment, vacationtime rentals, land, works of art, season tickets, and cemeteryplots might sound outlandish, but you will be surprised at whatsellers will take as a down payment if highly motivated.

• Escrow prorations and credits: Rental deposits can be credited aspart of the down payment, if not restricted by law. Other prora-tions such as rents and interest can also be used to adjust downpayments and loan balances. Credits for work can be completed,prorations of taxes, and insurance reduce cash outlays.

• Split downs: If a seller wants 20 percent down instead of 10 percent,try paying 10 percent at the close of escrow and 10 percent later.Compute interest as if it were an 80 percent loan.

There are both advantages and disadvantages in using any of thesedown payment strategies. Always be careful. Remember, money doesn’talways “talk.” Buyers and sellers have different needs. Finding and fill-ing them is the key to successful negotiating.

PROTECTING YOURSELF WHEN THE BUYER WANTS YOU TO PAY FOR REPAIRS

When repair work is needed, a credit should be issued toward the downpayment. The buyer can take the credit and do absolutely nothing, orget the work done. If the work is completed for less than the amount ofthe credit, the buyer pockets the difference. The seller is then releasedfrom liability.

If the seller continues to have an involvement in the property, byholding a trust deed or management contract, demand should be madethat all work be completed. Only in this way will the seller’s interestbe completely protected.

The best way to account for repair credits is to deposit the requiredfunds needed to complete the work in an interest-bearing fiduciary ac-count. It should be set up under the following terms:

• Limit your liability: Agree to maximum dollar and time limit.• Specific repairs: Only do agreed upon specific repairs. Use the in-

spection report as a reference. Don’t be vague. When it says plumb-ing repairs, it shouldn’t mean replace the plumbing in the entirebuilding.

• Approvals: Buyer should approve all completed work in writingbefore dispersing funds. Be sure to get all liens released. Requireseller’s approval of all work over a stated amount. Inspection

c09.qxd 4/5/04 11:37 AM Page 137


reports from either an inspection company or a property manage-ment company will help you negotiate repairs and replacementscosts on an item-by-item basis. It ’s important to scrutinize eachitem on the report. If the seller is in a hurry to sell, opportunitiesfor concessions may arise.

WHY “AS IS” IS NOW “AS WAS”

Some sellers advertise property on an “as is” basis. Most state laws ren-der these words meaningless. It ’s really not a “buyer beware” marketanymore. Don’t proceed under this false assumption. Placing thiswording in the contract doesn’t automatically release the seller from li-ability. Be sure all parties agree, in writing, to complete the transactionbased on the knowledge they have of the project. With the proper re-leases, a nominal sum can be paid as consideration to cover all repairitems. Confer with an experienced real estate attorney in this matter.

POSSESSION BEFORE ESCROW CLOSES—A GREAT STRATEGY FOR WHOM?

If extensive repairs are needed, try to take possession of the propertybefore escrow closes so that the work can be started immediately. Thisis a great strategy for the buyer, as it provides an opportunity to get anin-depth look at the building before escrow closes. Sellers have an in-herent danger in this arrangement. Buyers could nitpick the property todeath or uncover reasons not to close. Escrows can be strung out for in-consequential reasons. You’ve heard it said, “It isn’t over until it ’s over.”Well, it isn’t closed until it closes. Don’t get trapped by being an overlyaccommodating seller.

WHEN YOU SHOULD AVOID RAISING RENTS

If rental contracts do not reflect actual rents collected, the seller mustrectify the situation. It’s best to let the seller contact the tenants. Youshould always try to maintain a positive relationship with the tenants,especially during change of ownership.

When rents are low, they should be raised during the escrow period.The current owner will probably have greater compliance than you. Ifrents need to be raised substantially, there might be a number of evic-tions. This usually causes bad feelings and additional legal costs. It ’sbetter to have the seller deal with these headaches, especially if a rosyrental picture was painted on the set-up sheet.

c09.qxd 4/5/04 11:37 AM Page 138

BEWARE OF INDEPENDENT ESCROW COMPANIES 139

As the new owner, you might be able to offer the existing residentmanager additional incentives to initiate rent raises. Be careful. If theresident manager is the cause of many of the problems, don’t com-pound the problem. Remove the resident manager and have your prop-erty management company find a new resident manager immediately.

AVOIDING SALES TAX PROBLEMS

Valuations of furnishings can be used for depreciation and sales taxpurposes. Be careful when making these evaluations. Higher valuesplaced on personal property such as furniture could result in a highersales taxes liability. It also means a greater deduction for depreciation.The income tax saving must be weighed against the additional sales taxpaid when computing the IRR.

Sales taxes should be collected in escrow. Be aware that even thoughthe seller has primary responsibility to pay the taxes, the buyer is notcompletely off the hook until they are paid.

WHEN TO CLOSE ESCROW TO AVOIDCOLLECTING LATE RENTS

Try to close escrow at least 15 days after rents are due. This allows someof the “collection dust” to settle, and spares the new owners the task ofcollecting late rents. Have delinquent rents at the close of escrowcharged to the seller; then he is faced with the collection problem. Yourproperty managers can then concentrate on evictions, if necessary.Closing escrow the day rents are due puts the burden on you because,technically, there are no delinquencies.

BEWARE OF INDEPENDENT ESCROW COMPANIES

Knowing how to properly use the services of competent escrow com-panies will benefit you during negotiations. Be careful when using theother party’s escrow company, especially if they relate on a first namebasis. Biased interpretations of the purchase contract may end up onthe typed escrow instructions. If typed escrow instructions do not cor-respond exactly to the offer-to-purchase contract, refuse to sign themuntil they do—no matter how anxious the other party is to close. Thedelay is not your fault. Remember, time is on your side when the otherparty is anxious to consummate the deal.

Always negotiate escrow fees to reduce costs. This strategy is oftenoverlooked. There are no firm price tags for escrow services. Fees for

c09.qxd 4/5/04 11:37 AM Page 139


recording, typing, and notary can add up. Agree, up front, on one feeto cover all. However, using the other party’s escrow may work to youradvantage. The escrow officer may be willing to reduce fees and pro-vide additional services to everyone as an accommodation.

In circumstances where one party insists on opening escrow beforecontingencies are removed, be sure to route all correspondence throughthe escrow company. Inspection reports and approvals should be datedand recorded by the escrow company to properly document compliancewith deadlines.

REDUCING THE COST OF TITLE INSURANCE

The cost of title insurance can be reduced considerably if you knowwhat to ask for. Since title policy premiums are usually controlled bystate laws, they cannot be negotiated. However, there is a way to re-duce them when a short holding period is anticipated. Before escrowcloses, ask the title insurance company for a “short rate” or a binder. Ifthe property is sold within the binder period, a new title policy is notrequired. The cost for the binder at purchase is nominal compared tothe cost of a full-blown title insurance policy when you sell.

CONTROLLING ESCROW DEPOSITS

Funds held by the escrow company should be deposited in a bank ofyour choice earning the highest interest rate possible. If the escrow iscanceled, all funds should be returned to you without any offsets. In thereal world, this probably won’t happen unless it ’s specifically spelledout in the escrow instructions. The escrow company wants to be paid forits time and effort even if the transaction doesn’t close. To avoid thisproblem, try to remove all contingencies (with the possible exception ofthe loans) before opening escrow. It’s a lot simpler and less costly.

HANDLING COUNTER OFFERS

Make minuscule moves in price and terms when negotiating. If youoffer $1 million for a property and the seller wants $1.5 million, don’tcome back with $1.3 million. It’s too big of a jump. Try $1,050,000. Don’tget into the habit of splitting the difference and counter with a $1.250million. A good negotiator will spot this ploy every time and know heor she is dealing with an amateur.

Always know your parameters—“never” adjust them during face-to-face negotiations. If necessary, excuse yourself from the meeting

c09.qxd 4/5/04 11:37 AM Page 140

SUMMARY 141

and take time to analyze any new proposals. Everything must be eval-uated in terms of the IRR. Give yourself time to do it properly. Don’t beafraid to walk away temporarily.

Walking away from negotiations is an effective tactic. It gives bothparties time to think, and it creates the impression that you’re not mo-tivated. If offers and counteroffers are properly signed, the propertyis still under contract whether you walk away or not. If something fa-vorable doesn’t develop, you can always revert back to your previousagreement.

The one who is the least motivated has the greatest advantage. Neverforget that! Buyers should have several properties lined up to project alaissez-faire attitude. To be able to say “So what if I don’t buy your prop-erty, I’ll buy someone else’s,” or “It really doesn’t matter to me,” boostsyour negotiating position enormously. Sellers, on the other hand, shouldgive the impression that buyers are beating the door down to buy theirproperty.

HANDLING SELLER’S REMORSE

You should be buying in good locations where there’s a temporarydownturn or weakening of the local economy. The negotiating edge isyours because sellers are highly motivated. Normally, they are amiableto giving excellent terms and price. However, keep in mind that real es-tate ownership can be extremely personal, even in apartment buildings.Sellers might harbor deep emotional resistance. Although this senti-ment is not prevalent with investment property owners, it still exists.Proceed with care. Continually reassure the seller that he or she is mak-ing the right move. Always keep the seller informed. Communicate!Communicate! Communicate!

Initial reluctance on the part of sellers may result in offers beingrejected. Remember, acquiring a good apartment building is based onnumbers. Rejections, negative comments, and apparent lack of prog-ress could cause you to become discouraged. Be persistent! Never losetrack of what you’re trying to accomplish—financial freedom. It’s important to truly believe you’re on course. If you stick to the guide-lines in this book, you will find a suitable property and make theright deal.

SUMMARY

When do you stop negotiating? Never! Negotiate and negotiate, and then negotiate some more. Keep on negotiating until you can’t

c09.qxd 4/5/04 11:37 AM Page 141


negotiate any more. You’ll find that as long as you have an interest inthe property, you’ll probably continue to try to strike a better deal.

While negotiating, remember the other party is a competitor not apal. Stakes are high and the business at hand is negotiating. Stick tobusiness and play your hand properly. At the same time, treat everyonewith respect.

c09.qxd 4/5/04 11:37 AM Page 142

143

10Managing YourProperty Manager

Paramount to the success of any project is the full and proper utiliza-tion of a competent property management company. The efficient use ofthis qualified consultant provides the expertise needed to attain yourgoals.

Through proficient management, you’re able to control risks. Theseprofessionals will help you make the correct choices in acquisitions,operations, and selling. With a capable management team at your side,you’ll have an effective sounding board for new ideas. Their accurateand timely reports will give you the controls needed to detect problemsimmediately and take appropriate action.

THE OBJECTIVES OF A GOOD MANAGEMENT PLAN

What do you want to accomplish while you own the apartment com-plex? This question needs to be answered to formulate an effectiveplan of action. A written plan is essential. Unless they are in writing,specific goals could become blurry. Decisions may become counterpro-ductive without specific objectives.

A good management plan reflects the following investment strategy:Buying midsize apartment buildings in weak markets caused primarily

c10.qxd 4/5/04 11:38 AM Page 143

144 MANAGING YOUR PROPERTY MANAGER

by overbuilding, using little of your own capital, selling at or above re-placement costs, and holding on long enough to allow market condi-tions to improve. To accomplish this, concentrate on:

• Improving physical appearance• Increasing rental income• Reducing operating expenses

Information gathered during the inspection phase of the acquisitionshould provide most of the data needed to prepare a written manage-ment plan. Successful management companies have an operations orprocedural manual to assist in managing their properties. Use it to for-mulate your own management plan.

Communicate your management plan to all those involved. Anytimethere are changes, make sure everyone is notified. Constant and contin-ual communications are imperative to the success of your project. Peri-odic meetings and property inspections are also an essential part ofyour management plan.

Improving Physical Appearance

Concentrate on purchasing newer buildings. There’s usually less func-tional, physical, and economic obsolescence. Functional obsolescence occurswhen styles or construction methods change. For example, Victorian asopposed to modern, wood shingles to new fire-retardant materials, fusesto circuit breakers, water coolers to air conditioners, and so forth. Thistype of obsolescence can sometimes be cured by using updated materialsand equipment.

Physical obsolescence refers to the day-by-day wear and tear on abuilding by continual usage and climatic conditions. As things get old,they deteriorate. A determination should be made as to whether or notthe deterioration is irreversible. If it is, do not purchase the building. Itshould be demolished.

Economic obsolescence is a result of circumstances not directly relatedto the property. It is caused by location problems—a change in the zon-ing laws from residential to commercial or industrial, for example.

Newer apartment complexes requiring only cosmetic repairs shouldbe your prime target for acquisition. A management plan must rank ac-cording to priority those components of repair that will improve cashflow and maintain the building. The less out-of-pocket cash, the lessthe building has to appreciate to maintain the same IRR.

Expenditures for repairs should be made with an anticipatory pay-back period. If a unit requires paint, carpeting, and drapes, the

c10.qxd 4/5/04 11:38 AM Page 144

THE OBJECTIVES OF A GOOD MANAGEMENT PLAN 145

additional revenue generated must recover these costs as soon as possi-ble. Revenue is generated by reducing vacancies and increasing rents.Major capital improvement such as roofs and major plumbing havemuch longer pay-back periods.

Based on inspection reports, the management company should pres-ent plans to complete all necessary repairs and replacements, includ-ing estimated costs, time, and pay-back periods, in effect, creating anitemized monthly budget.

Increasing Rental Income

A marketing plan should be established to fill vacancies. It doesn’tmake sense to spend money on the building and not have a plan tokeep vacancies at a manageable level.

Your management company should know the demographics of ten-ants interested in renting your apartment complex and target a mediacampaign accordingly. Program proposals to attract these tenantsshould detail method(s) of implementation, costs, recommendations,and monitoring procedures.

There are questions that need to be answered: How will the existingtenants be handled? Will management move them out? Will they try toretain present tenants? What type of tenant retention programs andincentives do they specifically plan to use? What are the market tenantretention programs and incentives presently available? The goal in anycomplex is to create a community of friendly neighbors. People will re-spond favorably when working toward a mutually beneficial objective.This is the key to successful tenant relations.

Based on previous reports and surveys, detail projections shouldshow rent increases, unit absorption, and vacancies. These figuresshould be compared to the budget. Variances should be analyzed andadjustments made either in the budget or in marketing procedures.

Make your management company aware that you want your build-ing to be a rent leader rather than a rent follower. You want to be ag-gressive in rent raises to keep rents as high as possible. The first thingmost buyers and lenders look at is rental income. Once the local econ-omy starts to rebound, your rents should be in the top 90th percentileof similar buildings in the area. If they are not, your rents are too low.

Reducing Operating Expenses

An important function of the property manager is to reduce operatingexpenses. How will they accomplish this? What’s their plan? Howwill it be implemented? Look at each expense item on the statement of

c10.qxd 4/5/04 11:38 AM Page 145


operations and ask, point blank, “How do you plan to reduce these ex-penditures?” Evaluate answers as to credibility by consulting withother experts.

Reducing Insurance and Property Tax Expenses

A unique situation occurs when purchasing apartment buildings indown or weak markets. Property values have decreased. Because ofthis, assessments tied into these evaluations, such as property taxesand insurance, should be reviewed for potential savings. Overstatedproperty values should be appealed, and your property managershould request a reassessment. If it comes in lower, property tax andinsurance bills could be slashed considerably. To assure yourself thatyou’re paying the lowest possible premiums for property insurance,obtain at least three quotes from different insurance companies basedon this revaluation.

Comparing Your Apartment’s Performance to Other Complexes

Income and expenses should be compared periodically with the“Income/Expense Analysis: Conventional Apartments” published bythe Institute of Real Estate Management (IREM). See the sample inFigure 10.1 (pp. 148–149). This comparison will indicate whether ornot your figures are in line. Always ask for explanations whenevermajor differences occur.

PROPERTY MANAGER’S REPORTS

Your property manager should provide monthly operating reports thatfollow IREM’s format. Comprehensive monthly operating statementsshould include the following information:

• Receipts: Whether you call it an income register, a tenant depositregister, or a rent roll, what’s most important is that the reportcontain certain important information. Each apartment unitshould be listed numerically by size: number of bedrooms, fea-tures (location, patio, and views, for example). Include tenant’sname, security deposit, term, rent, date rented, delinquencies,and other income (garage, laundry, security deposits, latecharges, and so forth).

• Disbursements: Numerical listing of all checks written, vendoramount, account, brief description and listing of unpaid bills, anda copy of the bank reconciliation. One vital portion, often called

c10.qxd 4/5/04 11:38 AM Page 146

PROPERTY MANAGER’S REPORTS 147

an expense register must indicate which units that certain expensespertain to (HVAC replacements, plumbing repairs, carpets, orpainting, etc.). This is critical for budgeting and auditing pur-poses.

• Operating statement: On a cash basis, all income and expenseitems, actual compared to budget, including explanations of allvariances. There should be monthly and year-to-date columns forboth actual and budgeted amounts.

• Narrative: Summation of both current and year-to-date opera-tions, capital improvements, changes, or recommendations.

• Vacancies/Delinquencies: A report showing the vacant and delin-quent units for the current operating month. The vacancy portionshould list each vacant unit, condition of the unit, depositstaken/move-in date for new tenant, and when the unit was va-cated. The delinquency portion should show the balance due, theunit number, and status (date notice served, court date, lockoutdate, etc.). This information will tell you how aggressively yourmanager is collecting rents and renting up units.

• Market survey: Your property manager should provide you with awritten market survey (quarterly or semi-annually) showing yourproperty as compared to the market. At a minimum, it shouldcompare such factors as rent (by type of unit), required deposits,vacancy (by type), amenities, property conditions, incentives orconcessions, and advertising. Knowing how your property “mea-sures up” to your competition is critical to maximizing its perfor-mance and value.

• Annual budget: Your property manager should prepare a 12-monthcalendar year budget for all items listed on the operating state-ment. This budget should be prepared, reviewed and approved be-fore December 1 of the current year (year prior to the budget year).

These reports will help you direct the activities of your propertymanager. However, burying your head under reams of reports won’tget the job done. You can’t effectively manage your property unless youuse these reports wisely and take an active part in making decisions.As a part of the property management plan, make a commitment to seethe building periodically and to actively participate in its operations.

Defining Income and Expense Classifications

To maintain consistency in reporting, classify all income and expendi-tures according to the chart of accounts shown in Figures 10.2 and 10.3.This will assure “apples-to-apples” comparisons.

c10.qxd 4/5/04 11:38 AM Page 147

148

Se

lect

ed

Me

tro

polit

an

Are

as—

U.S

.A.

Me

dia

n I

nco

me

an

d O

pera

tin

g C

ost

sB

y B

uild

ing

Typ

e

Na

shvi

lle,

TN

Na

shvi

lle,

TN

Ne

w J

erse

y N

orth

ern

Low

Ris

e o

ver

24

Un

its

Ga

rden

Typ

e B

uild

ing

sE

leva

tor

Bu

ildin

gs

5 B

lgs.

66

1 A

pts

.4

5 B

uild

ing

s1

0,2

16

Ap

art

men

ts4

Blg

s1,

05

6 A

pts

.5

62

,82

2 S

qu

are

Fe

et

9,7

08

,46

3 R

enta

ble

Sq

ua

re F

ee

t1,

13

1,3

32

Sq

ua

re F

ee

t

%G

PI

$S

q.F

t.$

Un

it%

of

GP

I$

/Sq

.Ft.

$/U

nit

%G

PI

$/S

q.F

t.$

/Un

itB

ldg

s.M

ed

.M

ed

.M

ed

.B

ldg

s.M

ed

.L

owH

igh

Me

d.

Low

Hig

hM

ed

.B

ldg

s.M

ed

.M

ed

.M

ed

.

Inco

me

Ren

ts–

Ap

art

men

ts(5

)9

3.7

7.8

96

,15

0(4

4)

96

.49

4.7

97

.08

.54

7.2

99

.73

7,1

38

(4)

96

.72

9.1

43

3,2

54

Ren

ts–

Ga

rag

e/P

ark

ing

()

(5

).5

.04

39

(2)

4.4

1.5

81,

58

6R

ents

–S

tore

s/O

ffic

es

()

(1

)1

.2.1

21

12

()

Gro

ss P

oss

ible

Ren

ts(5

)9

3.7

7.8

96

,15

0(4

4)

96

.59

4.8

97

.08

.59

7.2

99

.76

7,1

38

(4)

97

.12

9.1

43

3,5

15

Va

can

cie

s/R

ent

Lo

ss(5

)7

.6.7

34

44

(42

)1

1.2

7.5

14

.6.9

1.6

71

.32

83

8(4

)1

6.5

3.7

04

,91

2T

ota

l Ren

ts C

olle

cte

d(5

)8

6.1

6.5

15

,39

4(4

4)

85

.48

0.9

90

.57

.39

6.4

28

.53

6,3

00

(4)

91

.12

7.4

62

7,6

58

Oth

er I

nco

me

(5)

6.3

.61

37

0(4

2)

3.9

3.1

5.3

.36

.24

.48

27

4(4

)3

.31

.00

1,1

52

Gro

ss P

oss

ible

In

com

e(5

)1

00

.08

.52

6,4

02

(44

)1

00

.01

00

.01

00

.08

.89

7.4

31

0.3

17,

38

2(4

)1

00

.03

0.1

43

4,6

67

To

tal C

olle

ctio

ns

(5)

92

.47

.15

5,8

21

(44

)8

8.9

85

.79

3.1

7.7

46

.66

9.1

36

,59

7(4

)9

4.4

28

.46

28

,95

6

Exp

ense

sM

an

ag

emen

t F

ee

(5)

3.7

.37

22

5(4

0)

4.0

3.4

4.6

.34

.28

.41

29

9(4

)3

.4.8

49

99

Oth

er A

dm

inis

tra

tive

**(5

)1

1.4

.80

73

3(4

4)

7.4

4.8

10

.0.6

4.4

3.8

56

08

(4)

2.5

.88

88

5S

ub

tota

l Ad

min

istr

ati

ve(5

)1

5.0

1.0

89

62

(44

)1

0.2

8.6

13

.0.9

8.7

91

.12

85

1(4

)6

.92

.04

2,0

49

Su

pp

lies

(4)

1.9

.18

11

1(3

7)

.3.2

.4.0

2.0

1.0

41

7(4

).5

.06

59

He

ati

ng

Fu

el-

CA

on

ly*

(5)

.6.0

54

4(3

1)

.7.5

.9.0

6.0

4.0

95

8(2

).0

.00

0C

A a

nd

Ap

art

men

ts*

()

(4

)1

.4.0

98

7(1

)4

.6.5

65

37

Ele

ctri

city

–C

A o

nly

*(3

)1

.2.0

97

9(3

7)

1.4

1.0

1.7

.13

.09

.16

11

1(2

)2

.3.5

16

83

CA

an

d A

pa

rtm

ents

*(2

)2

.6.1

91

65

(6

)1

.7.1

21

19

(2)

2.0

.54

61

7

c10.qxd 4/5/04 11:38 AM Page 148

149

Wa

ter/

Se

we r

–C

A o

nly

*(3

)4

.1.4

02

39

(14

)4

.63

.45

.0.4

3.3

6.5

03

49

(2)

.8.3

03

03

CA

an

d A

pa

rtm

e nts

*(2

)5

.8.4

03

72

(30

)5

.23

.56

.6.4

4.3

5.4

93

40

(2)

1.6

.19

18

7G

as–

CA

on

ly*

(4)

3.1

.24

21

9(1

5)

.3.2

.4.0

3.0

2.0

42

2(2

)1

.2.4

44

42

CA

an

d A

pa

rtm

ents

*(1

).3

.02

18

(9

).5

.04

35

(1)

.6.1

61

89

Bu

ildin

g S

ervi

ces

(4)

2.5

.17

16

0(3

5)

1.1

.41

.8.1

0.0

5.1

57

8(4

)1

.0.2

92

95

Oth

er O

pera

tin

g(3

)1

.1.1

26

9(2

2)

.5.1

.6.0

5.0

1.0

74

1(1

).1

.02

21

Su

bto

tal O

pera

tin

g(5

)1

0.0

.86

65

2(4

4)

8.1

6.6

10

.5.7

3.6

6.8

16

11

(4)

6.6

1.4

81,

48

6

Se

curi

ty**

(1)

.4.0

32

3(2

4)

.7.3

1.1

.06

.04

.09

50

(2)

7.4

.90

86

8G

rou

nd

s M

ain

ten

an

ce**

(5)

2.7

.25

17

7(4

2)

1.9

1.2

2.5

.17

.10

.24

14

8(4

).9

.22

27

6M

ain

ten

an

ce–

Re

pa

irs

(5)

2.3

.17

14

9(4

4)

3.3

2.4

6.4

.34

.20

.58

24

8(4

)2

.5.6

97

45

Pa

inti

ng

/De

cora

tin

g**

(3)

3.4

.23

21

4(4

2)

2.1

.62

.7.1

7.0

4.2

51

46

(4)

.8.1

61

56

Su

bto

tal M

ain

ten

an

ce(5

)8

.2.5

85

22

(44

)8

.77

.01

0.1

.77

.59

.95

63

8(4

)3

.41

.07

1,0

71

Re

al E

sta

te T

axe

s(5

)5

.9.4

13

77

(44

)6

.95

.57

.8.5

7.4

3.8

04

62

(4)

10

.72

.77

3,2

98

Oth

er T

ax

/Fe

e/P

erm

it(2

).1

.00

2(3

3)

.1.0

.1.0

0.0

0.0

12

()

Insu

ran

ce(5

)1

.1.0

86

9(4

4)

1.5

1.1

1.8

.14

.10

.15

11

1(4

).4

.13

15

2S

ub

tota

l Ta

x–In

sura

nce

(5)

8.6

.60

55

0(4

4)

8.6

7.3

9.5

.76

.56

.95

64

2(4

)1

1.0

2.9

03

,37

5

Re

cre

ati

on

al/

Am

enit

ies*

*(1

).1

.01

8(2

9)

.2.1

.2.0

1.0

1.0

21

1(3

).5

.11

14

1O

ther

Pay

roll

(3)

7.0

.50

45

0(3

3)

4.2

2.1

7.8

.44

.22

.58

33

2(4

)1

.1.2

92

91

To

tal A

ll E

xpen

ses

(5)

44

.14

.11

3,0

90

(44

)4

1.2

36

.64

5.8

3.7

93

.29

4.0

93

,01

4(4

)2

7.6

8.3

38

,94

6N

et

Ope

rati

ng

In

com

e(5

)4

2.6

3.6

32

,82

7(4

4)

47

.84

3.6

54

.34

.43

3.3

55

.24

3,7

30

(4)

56

.01

9.8

92

0,0

09

Pay

roll

Re

cap

**(4

)1

3.7

1.3

28

16

(38

)1

2.1

9.9

15

.01

.09

.92

1.2

38

97

(4)

7.9

1.6

11,

61

7

Fig

ure

10.

1M

etro

pol

itan

are

a re

por

ts. N

ote:

For

a de

scri

pti

on o

f U

tili

ty E

xpen

ses

(*)

and

Pay

roll

Cos

t (*

*) r

epor

ting

and

an

expl

anat

ion

of t

he r

epor

t la

you

ts a

nd m

etho

d o

f d

ata

anal

ysis

, ref

er t

o th

e se

ctio

ns

enti

tled

Gui

delin

es fo

r th

e U

seof

thi

s D

ata

and

Inte

rpre

tati

on o

f a P

age

of D

ata.

For

defi

nit

ion

s of

the

inc

ome

and

exp

ense

cat

egor

ies,

ref

er t

o th

e A

ppen

-d

ix. C

opy

righ

t ©

200

2, I

nst

itu

te o

f R

eal E

stat

e M

anag

emen

t.

c10.qxd 4/5/04 11:38 AM Page 149


QUALIFYING FOR THE MAXIMUM TAX WRITE-OFF

The IRS provides up to a $25,000 write-off to individuals who activelyparticipate in the management of a property. Active participation is de-fined as: “participating in the making of management decisions regard-ing a rental property (in a significant and bona fide manner), or thearrangement of others to provide services in an ongoing manner.”

The property management agreement should incorporate theseseven guidelines to assist in qualifying for the Active Participation Sta-tus according to IRS Code 469:

• Specifically state that the owner(s) will actively participate.• Owner(s) to authorize expenditures over a predetermined limit.• Only directed day-to-day operations to be performed by manage-

ment company.• Emergency repairs can be made without approval.

Income

1. Apartment Rentals: This figure should reflect all apartment rents whichcould have been collected, including employee apartments, if 100% of yourbuilding had been occupied.

2. Garage and Parking Income: If there is a separate charge made for use ofgarage parking areas, report the total amount that could have been collected,if 100% of this area had been occupied. If you include garage or parking areain the apartment rent, reduce the apartment rent total on Line 1 by the por-tion applicable to garages and parking and report this portion on Line 2.

3. Stores and Offices: Show the rental income you could have received fromstores and offices if both of these had been 100% occupied.

4. Gross Possible Rental Income: This is the total of Lines 1, 2, and 3.

5. Less Vacancies and Rent Loss: See Total Rents Collected.

6. Total Rents Collected: Show what you actually collected from all sources indi-cated on Lines 1, 2, and 3 (Apartment Rentals, Garage and Parking Income,Store and Office Income, and including the rental value of apartments given toemployees as part of their compensation). Then subtract Line 6 from Line 4(Gross Possible Rental Income) and enter the dif ference on Line 5 as Vacan-cies and Rent Loss.

7. Miscellaneous Income: Report here all the income collected from suchsources as maid service, gas and electricity sold to tenants, commissionsfrom telephones, laundry and vending machines, signs on the building, andair-conditioning charges. DO NOT include interest or dividend income.

Figure 10.2 Income form. Source: Institute of Real Estate Management,Income/Expense Analysis.

c10.qxd 4/5/04 11:38 AM Page 150

QUALIFYING FOR THE MAXIMUM TAX WRITE-OFF 151

• Capital repairs made under owner(s) directive.• Owner(s) establish rental terms/rates.• New tenants approval based on owner(s) established guidelines.

Establishing Active Participation

In addition to enumerating the conditions of active participation inthe property management contract, every owner should perform the

Figure 10.3 Expenses form. Source: Institute of Real Estate Management,Income/Expense Analysis.

c10.qxd 4/5/04 11:38 AM Page 151


following functions, not only to qualify as an active participant, butalso to adequately control his or her investment:

• Owner(s) should physically inspect the property prior to theclose of escrow and at least annually thereafter. Since a picture isworth a thousand words, it ’s best to take photos for discussionswith your consultant. Receive and review three estimates on allmajor improvements before authorizing the expenditure.

• Plan to meet at least semiannually. Record all meetings. Policyand procedural changes should be based on operating reports andphysical inspections.

• Owner(s) should either prepare a periodic independent rental sur-vey or arrange to have it done. Include such items as rental rates,amenities, or promotional specials, for example. They should beused to establish future rents and marketing strategies.

• Before locating a property, interview management companies todetermine which one best fulfills your needs. Evaluate each com-pany based on their procedures manual and the other criteria dis-cussed in Chapter 4 on consultants.

• To verify vacancies when doing physical inspections, tenantsshould provide move-in dates, monthly rent, and a securitydeposit.

• Obtain a printout of amounts paid to vendors. If one is used fre-quently, find out why. There could be a conflict of interest.

SUMMARY

The consultant who will affect the outcome of your investment themost is the property manager. If there is a definite plan for your build-ing, you will be able to maintain better control over its outcome.

When looking for apartment buildings, concentrate on projectswhere obsolescence is minimal. When you do make repairs, make aplan to recover your costs as soon as possible.

Always ask your property manager how he or she is going to increaseincome and reduce expenses on an item-for-item basis. Continuallycompare your apartment’s performance with others. Be sure the re-ports provided are adequately explained and use them to control yourproperty.

Be active in managing your investment. Not only do you receive sub-stantial tax benefits, but you also maintain control of your investment.

c10.qxd 4/5/04 11:38 AM Page 152

153

11Useful Strategies inMarketing Your Property

THE BEST TIME TO SELL YOUR PROPERTY

How do you know when to sell your property? Presumably, certain pa-rameters or goals were established at the time of purchase. Once theyhave been achieved, it ’s time to sell.

A good indicator of when to sell is an increase in residential build-ing permits. This usually occurs when selling prices become equal toor greater than replacement costs. Your apartment building should beput on the market as soon as you anticipate this happening. For exam-ple, if you purchased your apartment complex for $20,000 per unit andthe cost of replacement is $40,000, consider selling when market valuesbegin to approach the $40,000 mark.

Another indicator is when there are major changes in the vacancyand rental rates.

Never get greedy. Adhere to the established game plan. It’s trueyour apartment building might continue to go up in value, but youshould always be looking for opportunities to increase leverage. It’s

154 STRATEGIES IN MARKETING YOUR PROPERTY

part of the standard operating procedure (SOP). Don’t deviate from itby refusing to sell.

GETTING YOUR PROPERTY READY FOR SALE

Renovating income property is an ongoing process. By continuallyrenovating while you own the property, the value of the building will go up. Increasing the rental income is the key to increasingvalue. What should you be doing to increase the rental income? Youshould have a plan that includes a market study to determine whatthe cost of renovations will be and their impact on the rental incomeand property value. Determining what the rental of new constructionis in an area and what the potential rental value of the renovations is will give you a clear indication of how much you should spend and where.

To obtain the higher rentals, the first step is repositioning your prop-erty. Rename the complex to reflect a higher type building. Do not domajor remodeling, do cosmetic remodeling, including constructing a newfacade, repair work around the pool, and pool furniture, re-coating theparking structure, and painting the trim. Inside, the units should havenew carpeting or flooring. If the appliances are old try to get new appli-ances, lighting fixtures, blinds, new ceiling fans, and refurbish the cab-inets and counters.

Your renovation plan should weigh what the approximate cost willbe versus the expected return. The increase in income and valueshould be much higher than the actual cost.

Overspending will not make an old property competitive with newproperty. What you’re trying to do is reposition your older propertysomewhere below the new property as to rental income. If you spendtoo little, repositioning your property will not be achieved. Mainte-nance of property requires a plan that will increase the value of yourproperty and increase the rents.

Maintaining the property in top-notch condition at all times is asound management policy. Cosmetic improvements such as paintingand landscaping are inexpensive. A good appearance will help to bothrent and sell your apartment complex. It should always be maintainedin tip-top condition to attract the best tenants and the highest rents.Major renovations should be made when needed, not just to sell theproperty. The primary responsibility of a good property managementcompany is to see that renovations are carried out in a timely and ex-peditious manner.

CHOOSING THE RIGHT PERSON 155

YOUR MARKETING PLAN CAN BEINDIVIDUALLY TAILORED

When a group of investors owns an apartment complex, it is recom-mended that they have a written agreement defining the conditionsof sale.

If the group was formed using the method of ownership introducedin this book, each co-owner has the option to tailor the transaction tomeet his or her individual needs. Some owners might want all cash atthe time of sale. Others may simply trade or carry back notes. Havingthis flexibility makes it easier to sell.

CHOOSING THE RIGHT PERSON TO MARKET YOUR PROPERTY

Once the decision has been made to sell, you must establish whetheryou’re going to employ the services of a consultant, such as a real es-tate licensee or attorney, or market the property yourself. ReviewChapter 4 on consultants before making this decision.

How Much You Should Pay a Real Estate Licensee

Licensees can perform many of the services discussed in this chapter.They usually charge a commission based on a sliding scale. The higherthe selling price, the lower the commission and vice versa; however,keep in mind that there are no “standard” commission schedules. It’swhatever the market will bear. Commissions on lower priced apart-ment complexes should range between 3 and 6 percent. On the more ex-pensive ones, the range is 2 to 4 percent.

Remember, a consultant’s service can also be contracted out on anhourly basis instead of a commission. This arrangement might be lessexpensive, especially if conflicts of interest arise. However, whateverthe fee arrangement is, always get it in writing.

Having the assistance of a third-party when negotiating can be ad-vantageous. I’ve seen amiable face-to-face discussions between buyersand sellers turn into hostile confrontations. It’s easier to talk througha third-party consultant, especially if the atmosphere is filled withvolatile emotions.


AT WHAT POINT DO YOU BECOME LIABLE FOR REAL ESTATE COMMISSIONS?

Many real estate listing contracts provide that the procuring real estatelicensee is entitled to a commission. The licensees become procuringagents by presenting properties to potential buyers during the listingperiod and sometimes within a stated period thereafter. If one of thesepotential buyers attempts to circumvent the licensee to avoid a com-mission, they are legally barred from doing so. Never get involved withanyone who suggests it. In addition to being unethical, you’ll eventu-ally end up paying the commission anyway.

If a real estate licensee is not diligently working on your property,there are remedies governing broker/client relationships. Beating thelicensee out of a commission is not one of them. Always try to resolveany problems with the broker before going to any regulatory agencies.It is usually more effective and less time consuming.

DISCOVER AN EFFECTIVE WAY TO SELF-MARKET YOUR PROPERTY

If you decide to market the property yourself, using consultants on anas-needed basis, prepare a set-up sheet with a complete descriptionand operating information. Highlight the main features. It is an effec-tive tool in self-marketing your property. Include in your package inte-rior and exterior photographs that show its best features. Place youradvertisement in the newspaper, and return all calls immediately. Alloffers should be discussed with your consultant before responding.

An essential first step to successfully market your property is todetermine current mortgage conditions. Your strategy is based on it.Local lenders and loan brokers can be helpful in this endeavor. Ifmortgage money is plentiful, the buyer should secure new financ-ing. If not, you may have to finance part of the sale yourself. Be care-ful, some lenders won’t allow it. Make sure you’re working with onethat will.

MAKING YOUR NOTE MORE VALUABLE

Ideally, when you do sell, plan to have all your equity exchanged intoanother apartment building. However, if you have to carry back a note,be sure it has real value so it can either be sold or used as a down pay-ment for another property. The following provisions and conditions in-crease its value:

DETERMINING SELLING PRICE 157

• A higher rate of interest than current market• A shorter payback period (five years or less)• Amortized payment (both principal and interest paid monthly)• Ample buyer’s equity securing the note• Variable as opposed to fixed interest• Points for assumption• Acceleration clause• Maximum late penalties• Payee’s good credit rating

When using leverage, a good quality note can be equal to or greaterthan the value of cash for a down payment. It can also provide moreflexibility when planning tax strategies.

DETERMINING SELLING PRICE

To determine selling price, consider having a Member Appraisal Insti-tute (MAI) appraisal. It is a comprehensive report of the current value.This report will also assist in your marketing efforts. Other sourcesdiscussed in earlier chapters, such as local real estate boards, propertymanagement companies, and existing owners, can also be used to es-tablish a selling price.

Conservative Set-Up Sheets Are Important

Use actual numbers only, no projections or estimates, in the set-upsheets. The information supplied should be conservative. Inflated profitprojections will make potential buyers leery. If there’s any crystal ballgazing to be done, let the prospective buyers do it. You never know,their projections might be more generous than yours. Don’t put your-self out on this limb.

Make it absolutely clear on the set-up sheet that the resident managerand the tenants are not to be disturbed. Sellers sometimes let their res-ident managers know in advance that the building is being sold. Theseowners feel that it is better to learn about it from them, rather than tohear it from an “overly informative” buyer. Be careful. Resident man-agers’ perception of job security becomes cloudy when they know thebuilding is for sale.

Some owners, however, want to keep the lid on everything until es-crow actually closes, because if buyers don’t perform, day-to-day oper-ations can be needlessly disrupted. They feel it ’s better to let well


enough alone. What method you choose to handle this situation willdepend on your relationship with your resident manager.

Controlling Drive-By Inspections

Prospective buyers like to do drive-by inspections. A drive-by meansexactly that. It doesn’t mean having afternoon tea with the residentmanager. Make this perfectly clear in your set up. Also inform the res-ident manager that anyone without an appointment should be politelyescorted off the property. Dialog between resident managers andprospective buyers at this stage of your marketing program can becounterproductive. If you are not adamant on this point, you’ll end upwith managerial headaches.

Keep Your Property Management Company Informed

The property management company must be told that the building isbeing sold. They will be able to assist with all inspections, and they arein the best position to answer questions. As an additional incentive,this gives them the opportunity to make points with the new buyers.

What to Do When Dark Clouds Appear on the Title Report

As an added precaution, have the title report updated. If there are anydark clouds hanging over the title, you should know up front beforespending time and money on a marketing program. Make sure thatthese problems are corrected. Contact the title company or your attorneyto help you clear the title.

Looking for Buyers

The first place to look for prospective buyers is in the county records.Apartment owners who own property in the same general area as yourbuilding are excellent prospects. Contact them to see if they’re inter-ested in buying. You’ll be surprised at the response. People tend to grav-itate toward similar investments. Stock market investors generally stickwith stocks, real estate investors with real estate, bonds with bonds, andso forth.

A Successful Newspaper Advertisement

Have newspaper advertisements run in both the local and nearest bigcity Sunday editions. Don’t waste your advertising dollars on the

PROTECTING YOURSELF 159

other days of the week. Serious apartment buyers primarily look atthe Sunday newspapers. The advertisement should include the fol-lowing information:

• Number of units and the unit mix• Price and down payment• Special seller financing• Location—city or section of town• If it ’s a new or newer building• One or two special features• Phone number• Selling by owner

If your advertisement is not producing results, change it every othermonth. Phrases like “flexible terms” and “submit all offers” will gen-erate additional interest.

Don’t overexpose the property. Buyers might think something iswrong. Very little or no response could mean discontinuing the adver-tisement for a few weeks. When you do resume, create a new advertise-ment. Instead of weekly, try advertising every other week.

Responding to an Offer

When inquiries are received, set-ups are sent, and prospective buyersare contacted. The ball is now in motion. Remember, send set-upspromptly. Follow up within a few days with a telephone call. Makenotes of all conversations. These notations will help you to monitor themarketing program. If the selling price and/or down payment are toohigh, financing is not available, or market conditions have changed, itwill readily become apparent when analyzing your notes.

As your marketing activity grows to a crescendo, and you start re-ceiving offers, review Chapter 9 on negotiations. After you’ve done that,take a deep breath. The battle is beginning.

PROTECTING YOURSELF WHEN YOURPROPERTY IS TIED UP

Negotiating from the seller’s position is just the reverse of the buyer’s.Time is not on the side of the seller; therefore, taking your property offthe market for any length of time isn’t to your advantage. To avoid this,be sure all buyers contingencies have an expiration date. Use a specificdate (not number of days) when removing contingencies. Using num-ber of days to remove contingencies can cause uncertainty as to the


actual start date, especially if it ’s dependent on a nebulous event. Forexample, if the inspection of all books and records is to be made within10 working days of receipt, who determines if all the books and recordshave been received? Buyers can stall by continually asking for moreand more information and can extend those 10 days ad infinitum. Toavoid confusion, always use a specific date rather than number of daysto remove contingencies!

DETERMINING IF YOU HAVE A REAL BUYER

Before accepting an offer, gather as much information as you possiblycan about the buyer—credit reports, financial statements, track record,and references. The buyer’s track record will show if he or she is expe-rienced in similar transactions. It’s easier to work with experiencedbuyers than holding hands with one who’s not. They’ve been through alearning curve so they’re able to make decisions quickly, thereby re-ducing the amount of time your property is off the market.

To be certain you’re working with a real buyer, have the buyer re-lease the deposit to you as soon as all contingencies (other than loanapproval) have been removed. If a qualified buyer is genuinely seriousin closing the transaction, there shouldn’t be any objection to this re-quest. If the buyer says, “Suppose you back out of the deal, I have noprotection.” You should answer, “You can put a cloud on the title and Iwon’t be able to sell it to anyone.” This cloud is called a lis pendens. Itgives constructive notice to anyone interested in your property thatlegal action is about to be taken. The outcome might have serious im-plications as to the marketability of the property, as your property canbe tied up in legal proceedings for years.

GETTING OUT OF ANY CONTRACT LEGALLY

Always be careful when signing offers and counteroffers. A legallybinding contract can be created once your signature goes on the dottedline. Unless you’ve retained an escape clause, your property is effec-tively taken off the market. Phrases like “subject to the approval of” myattorney, the co-owners, my property management company, my wife,or my astrologer are all legitimate reasons to beat a path out the backdoor and out of the contract.

CLOSING THE SALE WITH NO STRINGS ATTACHED

Don’t deposit funds into an escrow account for repairs. Funds tied upunder this arrangement subject you to further involvement in the

SUMMARY 161

property while waiting for the work to be done. Don’t tie yourselfdown. Go on to other deals. If repairs are required, reduce the sellingprice instead. Be sure the buyer releases you from all claims when youdo. Have your attorney prepare the paperwork.

Remember, reducing the selling price will lower both income andproperty taxes. This is an added benefit to buyer and seller.

Have all documentation routed through the escrow company. It is aneffective way to authenticate “received” and “sent” dates. Questionsthat may arise later as to whether paperwork was received on time canbe verified by simply referring to the date stamp.

All walk throughs and physical inspections should be conducted bythe property management company. They are knowledgeable about alllegal requirements for tenant notices and should have sufficient infor-mation as to the condition of the building to answer any and all ques-tions. The management company should properly notify all vendorswhen the building is sold to avoid further liability. Keep copies of thesenotifications in your permanent files for protection.

SUMMARY

If you really want to sell your property, be serious in your efforts.Don’t waste your time and the time of potential buyers exposing yourproperty just to see what it’s worth.

When working with a broker, be sure a marketing plan is submittedthat includes advertising recommendations (with budgets), methods ofevaluating potential buyers, and cooperative agreements with other realestate licensees. Ask for specific dates as to when each aspect of the mar-keting plan should unfold. Establish a reporting system and monitor itclosely.

If you are marketing the property yourself, prepare conservative, ac-curate, and professional-looking set-up sheets. Follow up quickly andnever stop selling.

Time is on the buyer’s side. Don’t let unqualified buyers take yourproperty off the market.

Be careful when signing. Remember when you put your signature onthe line, you’re in all likelihood, activating a legally enforceable con-tract. Keep your attorney close by and use him or her!

Buyers, like newborns, come anytime, day or night. Always be readyto deliver!

163

12The Internal RevenueService’s Best Kept Secret

Income tax liability is derived by multiplying taxable income by the ap-plicable tax bracket rate. The lower the taxable income, the lower therate, thus the lower the tax liability. Herein lies the secret to significanttax savings. Reduce taxable income, and, in turn, tax liability will beless. According to John T. Reid in his book Aggressive Tax Avoidance forReal Estate Investors (Reed Publishing: Danville, CA, 1994), the goal fortax planning is to maximize after-tax income, not minimize taxes. Tomaximize after-tax income, you have to reduce the income tax liability.That’s the primary goal of all tax planning. Let’s find out how this isaccomplished.

WAYS TO LOWER TAXABLE INCOME

This chapter gives you a basic understanding of the following threesimple underlying concepts used to reduce taxable income:

1. Spread income over time2. Spread income to various entities3. Group income and expenses

c12.qxd 4/5/04 11:38 AM Page 163

164 THE IRS’S BEST KEPT SECRET

Knowing something about each of these concepts will permit you tointelligently implement a sound tax program. With the assistance of acompetent tax advisor, your tax savings will be significant.

Spreading Income over Time

Real estate provides the opportunity to spread income over severalyears using the installment sales method of reporting. By accepting arelatively low down payment and spreading the principal paymentsover several years, total taxable income for any one year is reduced.

In the tax-deferred exchange method, income can also be spreadover time. Both methods can be structured to give you maximum re-porting flexibility.

If you’re a real estate licensee purchasing a property and you want tospread taxes on your commissions over time, have them contingent uponsome event taking place to avoid constructive receipt, if the situationwarrants. For example, your commissions could be conditioned upon theproperty maintaining certain levels of cash flow and/or profits.

Spreading Income to Various Entities

Spreading income to various entities reduces the income any one entityhas to report. By transferring ownership of assets to either corpora-tions, partnerships, relatives, or trusts, an effective transfer of incomecan be accomplished as well.

Relatives in low-income brackets can be paid for services provided.As long as these services represent legitimate business transactions,spreading income in this manner can save you thousands of tax dollars.

When operating entities have dissimilar tax reporting years andbasis (cash or accrual), it ’s possible to spread income and expenses overdifferent years to take advantage of the tax laws.

Group Income and Expenses

Grouping income and expenses can lower taxable income. Real estateprovides the flexibility to implement this kind of tax-planning tactic.More specifically, apartments do, because they fit nicely within thedefinition of active participation rules (which allow a $25,000 write-offagainst salaries and other active income). This write-off alone repre-sents a substantial tax savings to many individual investors. See thesection on this loophole on p. 167.

When changes in either income or expenses can be projected, the ben-efits of grouping are phenomenal. For example, refinancing will create a

c12.qxd 4/5/04 11:38 AM Page 164

INCREASING THE DEPRECIATION DEDUCTION 165

higher interest expense deduction to offset anticipated increases inrental income. Short-term loan contracts with high points will accom-plish the same thing.

If expenses are projected to increase, offset them by increasing re-ceipts from installment contracts. Avoid reporting income when notesbecome due by renegotiating an extension of time. If the senior mort-gage matures before your note, subordinate it to new financing to avoidpayment.

Investing in midsize apartments gives you the advantage of acquiringproperties outside your hometown. As a result, travel and transportationexpenses related to your investments can be deducted. These deduc-tions should be timed to give you the maximum tax savings using the“grouping method.” By rearranging the selling price and interest rate(within certain limitations), it is possible to create either higher or lowerinterest and/or depreciation expense deductions.

Capital gains and losses can also be grouped to maximum tax bene-fits. With restrictions, capital losses may be used to offset capital gainsplus additional amounts of ordinary income.

These represent only a few of the many techniques available. Alwaysconsult your tax advisor to assist you in making these moves.

INCREASING THE DEPRECIATION DEDUCTION

Maximize the deduction for depreciation:

1. To increase the depreciable basis of the asset, take the higher ofeither the tax role or an independent appraisers evaluation.

2. To decrease the length of time the asset is depreciated, identifypersonal property assets. They can be depreciated over shorterlives.

Various methods of depreciation are used for different classifica-tions of personal property. Properties with lives of three, five, seven,and ten years may be depreciated by the 200 percent declining balancemethod. The greater the depreciation, the higher the expense deduc-tion, and the more the Internal Revenue Service (IRS) helps to pay foryour investment.

Converting Real Property into Personal Property

The IRS defines tangible personal property as any personal property ex-cept land and improvements thereto, such as buildings or other in-herently permanent structures (including items that are structural

c12.qxd 4/5/04 11:38 AM Page 165


components of such buildings or structures) (Reg. 1.48-1[c]). Thecourts have concluded that “permanency” is the most pertinent test inthe determination of whether an asset is a structural component andnot personal property. They have applied six tests to assist:

1. Is the property capable of being moved and has it in fact beenmoved?

2. Is the property designed or constructed to remain permanentlyin place?

3. Are there circumstances that tend to show the expected or in-tended length of affixation?

4. How substantial a job is the removal of the property and howtime-consuming is it?

5. How much damage will the property sustain upon removal?6. How is the property affixed to the land?

Personal Property Items Found in Apartment Buildings

The following represent assets found in apartment complexes that nor-mally qualify as personal property:

• Furniture such as beds, tables, chairs, lamps, and sofas• Carpets, drapes, blinds• Security and decorative lighting• Refrigerators, garbage disposals, washers and dryers• Pool equipment and furnishings including pumps and filtering

apparatus• Recreational equipment pool table, weights, and exercise equip-

ment

Typically, personal property amounts to less than 3 percent of thebuilding’s component costs. The remainder of the apartment is as-signed a depreciable life of 27.5 years. The trick is to hire a cost segrega-tion analyst, who maximizes the benefits by identifying, classifying,and segregating more than 3 percent of the building’s assets for an ac-celerated depreciation for federal income tax purposes. This may mean3 to 20 times more savings than the 3 percent found in identifying per-sonal property. Power outlets in the office, decorative paneling in yourreception area and conference room, oversized cooling systems, andkitchens are just a few items that a cost segregation specialist looks forwhen working to identify a tax savings in your apartment building.

The personal property assets are grouped under several IRS classifi-cations. The cost segregation specialist identifies which components of

c12.qxd 4/5/04 11:38 AM Page 166

THE LAST REMAINING LOOPHOLE 167

each system, according to federal tax laws, can be assigned acceleratedlife of 5, 7, or 15 years rather than the straight line of 27.5 years. Costsegregation studies should be initiated as early as possible during theacquisition process to obtain the maximum tax savings.

Remember, by maximizing the deduction for depreciation, you in-crease your after tax internal rate of return (IRR). That’s the moneyyou put in your pocket without the IRS going in after it.

THE LAST REMAINING LOOPHOLE THATSURVIVED TAX REFORM

Apartment ownership still provides the opportunity to easily qualifyas an active participant. In doing so, qualified owners can deduct up to$25,000 per year against salaries and other nonpassive income. You’llnotice that I said “qualified owners.” That’s because there are five basicconditions that must be met to qualify for this write-off:

1. The person seeking the write-off must be an individual taxpayer.Corporations and limited partners do not qualify. The IRSconsiders a married couple filing jointly to be an individual, so ahusband and wife can share the write-off. Tenants-in-commonform of ownership meet this requirement.

2. The property must be a real estate rental activity. That is, its pri-mary purpose must be that of a rental. Apartment buildings qual-ify beautifully.

3. The individual must own a minimum of 10 percent of the rentalproperty at all times. A husband and wife can own 10 percentcombined and still qualify because they’re considered to be an in-dividual by the IRS. An individual may own more than 10 percent,but not less.

4. The maximum write-off of $25,000 is phased out when adjustedgross income (AGI) exceeds $100,000. The phase-out is $2 for each$1 of AGI over the minimum of $100,000 for married taxpayerfiling jointly. This exemption is unavailable once AGI reaches$150,000.

5. The individual must be considered an active participant. The activeparticipation standard requires only that the individual partici-pate (in a significant and bona fide manner) in the making ofmanagement decisions or arranges for others to provide services.Examples of management decisions would include setting rentalrates and terms and approving capital and repair expenditures.A management company can handle the day-to-day operations aslong as the owner makes the major decisions.

c12.qxd 4/5/04 11:38 AM Page 167


It is difficult to get this deduction owning real estate other thanapartment buildings. The tax codes have specially questioned whethertriple-net lease arrangements found in shopping centers, office build-ings, and industrial parks meet these requirements. Apartment com-plexes fully comply because rents are generally on a gross not on atriple-net basis.

DEDUCTING ACCRUED INTEREST WHENYOU’RE ON THE CASH BASIS

Some consider accrued interest to be the single most important deduc-tion in apartment investing. However, many taxpayers are on the cashbasis and can’t benefit from it unless they file on the accrual basis. TheIRS has to be notified when this change is made, and there are restric-tions. This area of real estate tax law is not well known. The require-ments necessary to deduct accrued interest when you’re on the cashbasis include considerations of:

• The all-events test and economic performance• Accounting method• Limitations

The All-Events Test and Economic Performance

In general, accrued interest expenses are not deductible for cash-basistaxpayers unless the accrual method of accounting is used and the all-events test is met, but not earlier than when economic performancewith respect to when such items occur (Code Sec. 461[h]). The all-events test is met if all events have occurred that determine the fact ofliability and the amount with reasonable accuracy.

Economic performance has special rules for tax shelters. Any entity,if more than 35 percent of its losses are allocable or any investmentplan, the principal purpose of which is the avoidance or evasion of fed-eral income tax (Code Sec. 461 [i][3]), is considered to be a tax shelter.Also, under the 1986 Tax Reform Act Code Sec. 448, a tax shelter maynot compute its taxable income on the cash basis. Once under the taxshelter rules, the recurring item exception under economic performancedoes not apply. Generally, economic performance occurs within theshorter of a reasonable period after the close of such taxable year oreight and one-half months after the close of such taxable year. Economicperformance occurs for a tax shelter at the time the property is pro-vided to the taxpayer by another person (Code Sec. 461 [h][2][ii]).

c12.qxd 4/5/04 11:38 AM Page 168

DEDUCTING ACCRUED INTEREST 169

Accrued interest expense will qualify for the deduction at the time theapartment is purchased from the seller. Because (1) the property is pur-chased from another party, (2) the fact of the liability has been deter-mined with reasonable accuracy, and (3) economic performance occurssince the seller provides the property to the buyers.

Accounting Method

Can an individual use the accrual method of accounting whose over-all method is on the cash basis? The code specifically provides that theIRS commissioner’s consent must be obtained before changing themethod of accounting (Code Sec. 446 [e]). However, the regulations alsoprovide that the first tax return on which the item involved is reportedmay incorporate any appropriate method of accounting without thecommissioner’s consent. A taxpayer may adopt any permissible methodof accounting in connection with each separate and distinct trade orbusiness, the income from which is reported for the first time (Reg. 44-1[e][1]). In addition, where a taxpayer has two or more separate and dis-tinct trades or business, a different method of accounting may be usedfor each trade or business, provided the method used clearly reflects theincome of that particular trade or business.

The method first used in accounting business income and deduc-tions in connection with each trade or business, as evidenced in thetaxpayer’s income tax return in which such income or deduction isfirst reported, must be consistently followed thereafter. No trade orbusiness will be considered separate and distinct unless a completeand separate set of books and records are kept for such trade or busi-ness. Also, if by reason of maintaining different methods of account-ing, there is a creation of shifting of profits or losses between tradesor businesses of the taxpayer so that income of the taxpayer is notclearly reflected, the trades or businesses of the taxpayer will not beconsidered to be separate and distinct (Reg. 1.466.1 [d]). If the aboverules are satisfied, the rental activity qualifies as a distinct trade orbusiness; then the “change in method of accounting” rules will notapply since the activity involved will be reported for the first time.Consequently, the overall cash method of accounting for the individ-ual doesn’t have to be changed.

It is important that a rental activity qualify within the definition ofa trade or business. Neither the law nor the regulations provide a cleardefinition of what is meant by a “trade or business.” This is because noone definition can consistently apply to all situations. There are how-ever various tax cases that support rental property as being a trade or

c12.qxd 4/5/04 11:38 AM Page 169


business (Hazard and Lagreide). Management activity and ownershipalong with specific facts will determine this issue.

Limitations

The investment interest deduction is limited to the taxpayer’s net invest-ment income for the taxable year (Code Sec. 163 [d][1]). However, underCode Sec. 162 (d)(3)(B), the term investment interest does not include anyinterest taken into account under Code Sec. 469 in computing income orloss from a passive activity. What is considered a passive activity? Anyactivity that involves the conduct of a trade or business and which thetaxpayer does not materially participate (Code Sec. 469 [c][1]) is passiveactivity. In addition, the definition includes any rental activity, whetheror not the taxpayer materially participates (Code Sec. 469 [c][2]).

Rental activity is considered a passive activity. Under these rules, de-ductions from passive trade or business activities to the extent that theyexceed income from all such passive activities generally may not be de-ducted from other income. However, relief is provided for rental realestate activities in which the taxpayer actively participates. If an indi-vidual qualifies under the active participation rules, up to $25,000 ofpassive losses can be deducted against income from nonpassive sourcessubject to the phaseout previously mentioned.

YOU SHOULD ALWAYS DEFER PAYING TAXES

As a rule of thumb, it is best to defer payment of taxes to a later datebecause:

• You’ll be paying with inflated dollars. During periods of infla-tion, obligations paid at a later date are, in effect, paid with in-flated dollars. For example, if a $100 tax bill can be deferred forfive years, the purchasing power of those dollars, when paid,will only be worth $75 (assuming a 5 percent annual inflation).The IRS’s loss can be your gain if you’ve invested wisely duringthose five years.

• More investment dollars will be at your disposal. The fewer dol-lars expended for taxes, the more will be available to investments.“Before tax dollars” investments will net a higher rate of returnthan those made with “after tax dollars.” Simply, you have moremoney to work with. In a tax-deferred exchange involving “grossequities,” more investment dollars are available to work with tosubstantially increase your net worth.

c12.qxd 4/5/04 11:38 AM Page 170

CATCH-UP DEPRECIATION 171

• The government giveth and taketh away. Take advantage of every-thing and anything the IRS gives you whenever it’s given. You’llnever know whether or not it ’ll be taken back. This has alwaysbeen my philosophy. Make it yours, too.

HOW TO NOT PAY ANY TAXES ON CAPITAL GAINS

Based on a new tax law, you can avoid capital gains if you follow thesestrategies. Example one: If you have a rental property and you sell it for$3 million and your cost is $1.5 million, your profit will be $1.5 million.Your taxes on the profit will be between $500,000 and $700,000. You andyour spouse or significant other can avoid paying those taxes by tradingfor three single-family rental properties—Property A, Property B, andProperty C. You then rent them out. If you try to rent Property A andyou can’t, live in it for two years and sell it, the $500,000 profit based onthe new tax law, is excluded. Then you move to Property B and live in ittwo years. When you sell it, you do not pay any taxes on the $500,000.Then, live in Property C for two years. Sell it and you don’t have to payany taxes on the $500,000 either.

Example two: Sell your rental property for $3 million to a limitedpartnership whose partners are not blood relatives. Take $1 down and anote for $2,999,999. The tax on that dollar is 33 percent. The limitedpartnership sells the property for fair market value to an unrelatedthird party for $3 million. The tax is zero because the basis is $3 million.The partnership can pay you installment principal payments on yournote, and you’d be paying percent taxes on that profit. But you’d bespreading income over a number of years. You can gift portions of thatnote to individuals, thereby spreading the income over entities. Or youcan leave it in your estate; it is possible that you will not have to paytaxes on it at all.

CATCH-UP DEPRECIATION

New IRS tax laws allow you to take what’s called catch-up depreciationdeductions that you have not previously taken. This procedure allowsyou to take the entire deduction in the current year. The election mustbe made in the first half of the tax year in which the catch-up deductionwill be taken. This method benefits anyone who is allowed to take a de-preciation deduction. For example, if you didn’t take deductions in theprior years for one reason or another, and you decide, based on your in-come, to offset an anticipated increase in income with catch-up depre-ciation, you may do so. This is called grouping income and deductions.

c12.qxd 4/5/04 11:38 AM Page 171


LANDLORD/LEASEE TAX STRATEGIES

Instead of paying for the lease improvements, have your landlord payfor any lease improvements. The landlord can write these lease im-provements off over a 39-year period. If you made the lease improve-ments and paid the cost of the improvements, you would have to writethem off over 39 years. To increase the deduction, pay for the cost ofthese improvements by increasing the rent. Therefore, you’re accelerat-ing the rent expense instead of deducting the lease improvements over39 years. The landlord is reimbursed for the improvements in the formof rent payments and also enjoys the annual deduction for the apprecia-tion. Instead of spreading the cost of these improvements over 39 years,you’re actually spreading them over the life of the lease which could beless than 39 years.

HOW TO MAKE A TAX DEDUCTIBLE GIFT

If you give your children a gift every year for tax purposes, it is not de-ductible. But you can instead treat your child’s home as your secondhome and make the mortgage payment on it. This only applies if youdon’t own a second home yourself. The same strategy can be used tomake gifts to your parents or certain other family members. Make thehome mortgage payments for them and deduct the mortgage interestportion of the payment on your tax return. This will free up cash foryour children or parents that they would otherwise have used for mort-gage payments. In this way, you’re indirectly making a tax-deductiblegift to your children. Interest payments must be legally enforceabledebt, therefore, you must co-sign the loan. This strategy is called spread-ing the income and deductions to entities. If your family members are in ahigher income bracket, it won’t work. It doesn’t have to be made on thesame house each year. For example, if you have five family members andyou co-sign on all five loans, you can make loan payments in any oneyear to any one of the five. Children are not the only ones who qualify.You can also have this arrangement for your parents, grandparents,grandchildren, or your brother or sister.

GIVE THE BOOT TO BOOT

Based on an IRS revenue ruling, it is now possible to offset boot (seeGlossary) with other transactional expenses. For example, if an investortraded down from a $500,000 property to a $400,000 property, a $100,000

c12.qxd 4/5/04 11:38 AM Page 172

TAX-DEFERRED EXCHANGES 173

boot would be recognized. When the transaction is reported, he auto-matically reduced the amount of the $100,000 boot by all transitionalcost, such as commissions and other closing costs incurred.

UNLIMITED REAL ESTATE LOSSES FORREAL ESTATE PROFESSIONALS

The new law now makes individuals eligible to deduct real estatelosses if:

1. More than half of all personal services they perform during theyear are for real estate trade or businesses in which they materi-ally participate.

2. They perform more than 750 hours of service per year in thosereal estate activities.

Unlimited loss deductions are adjustment to adjusted gross income(AGI), and they’re not subject to the same limitations as deductionsfrom adjusted gross income. Rules in a calculation can be complicated.For a specific advice, it ’s recommended that you contact your accoun-tant or your tax attorney.

LIKE-KIND EXCHANGES INCLUDE LEASES

General short-term leases (less than 30) do not constitute a like-kind ex-change with real property. However, lease hold interest with 30 years ormore remaining at the time of transfer may be treated as a like-kind in-terest for the purpose of the 1031 tax-deferred exchange (see next sec-tion). Tax considerations may vary based on who gives and receives thelease as to rents and the nature of the transaction. Arrange the lease tobe initially six years with five additional renewal options. The optionsare exercisable without obtaining consent from the lessor.

TAX-DEFERRED EXCHANGES

A fantastic way to take all of your profits from a sale of real estate andput it into a new property without having to initially pay taxes is donethrough 1031 tax-deferred exchange. Funds from the sale should be heldby a qualified intermediary or an accommodater until the exchangetransaction is complete and the requirements have been met. You have 45days from the date escrow closes to identify an “up property” and 180

c12.qxd 4/5/04 11:38 AM Page 173


days to complete the exchange. The 180 days includes the 45-day identi-fication period. If you receive cash or reduction in the mortgages, it ’sconsidered boot and you have to pay capital gains taxes on it. One of theadvantages of doing a tax-free exchange is that you retain more of thefunds for investment and defer taxes to a later date. Postponing the taxesis a good tax strategy because, when the taxes are finally paid, they’regenerally paid with inflationary dollars. The longer the payment is de-layed, the lower the present value of the taxes, and the larger the benefitof the deferment. Also, when the property is transferred at death, thebasis is adjusted to current market values, thus all or mostly all of thedeferred capital gains tax liabilities can be eliminated.

REVERSE EXCHANGES

The IRS allows investors to do a tax-deferred exchange in reverse. Basi-cally the guidelines are the same as a forward exchange. The reverse ex-change avoids both time and constraints by closing the purchase of thereplacement property prior to the sale of the existing property. In doinga forward exchange, the investor cannot take control of the proceeds orthe exchanged property. The accommodater takes control of the prop-erty and the proceeds. Basically, the “up property” is purchased priorto selling the existing property. The forward exchange and the reverseexchange are complicated and we recommend that you use the servicesof a qualified accountant or attorney and a qualified intermediary or anaccommodater.

DEPRECIATING LAND COST

The cost of land cannot be written off for tax purposes until the land issold. Yet under certain conditions, some land improvements can be de-preciated over 15 years. This depreciation deduction can provide sub-stantial tax savings.

Not all real estate property is real estate under Modified AcceleratedCost Recovery System (MACRS). For example, single-purpose agricul-tural structures are in the seven-year class. More importantly, land im-provements are not included in the definition of 27.5-year residentialproperty. Land improvements such as parking lots, sidewalks, roads,landscaping and fences have a 20-year midpoint, and are 15-year recov-ery properties under MARCS. Thus land improvements, a major ex-pense of any large project appear to qualify for 150 percent decliningbalance recovery over a 15-year period.

c12.qxd 4/5/04 11:38 AM Page 174

SUMMARY 175

PAYING CAPITAL GAINS . . . A GOOD STRATEGY

The capital gains rates at this printing are being reduced from 20 percentto 15 percent. It just might be wise to pay the capital gains and take agreater basis for the depreciation deduction on the “up property.” Thisshould be considered in your tax planning. On the other hand, if youhappen to be in the 10 percent to 15 percent regular income tax bracket,the rate for capital gains starts at 8 percent. For assets held for at least afive-year period and sold after December 31, 2000, it might behoove youto just pay the capital gains taxes at the lower rate and not be subjectedto the time constraints of a 1031 tax-deferred exchange. You might possi-bly find a much better deal given enough time.

SUMMARY

This chapter is by no means a complete guide to real estate taxation. Itsprimary purpose is to make you aware of areas in the tax codes that areimportant to investing in apartment buildings.

Choose a tax consultant knowledgeable in real estate taxation. Theexplanation of accrued interest is comprehensive because of its signif-icance in tax savings. References to IRS codes will be of assistance toyour tax advisor.

Whenever you can get the IRS to underwrite your investment, you’llbe money ahead. When you apply this strategy, you’ll be working withwhat is known as “soft dollars.” This simply means that the IRS is pay-ing for your investment, and the “hard dollars” (your own money) ex-pended will be fewer. Never forget, however, the IRS has the divineauthority to broadly interpret the tax strategies discussed in this chap-ter and reserves this consecrated right to draw diverse conclusions.

If there’s a reasonable basis for a deduction, our philosophy is“When in doubt, DEDUCT.” Ask yourself “What is my down side?”The answer is practically nothing. At worst, you’ll have to pay the taxesplus interest, which, by the way, has been historically low. Profits fromthe money invested may more than offset the rate the IRS charges.

The suggestions in this chapter will help you avoid—not evade—pay-ing taxes. The former can save you money, the latter will cost not onlymoney, but may also cost you your freedom!

c12.qxd 4/5/04 11:38 AM Page 175

c12.qxd 4/5/04 11:38 AM Page 176

177

13Introducing Tenants-in-Common Formof Ownership

In this book, I recommend purchasing midsize apartments. Buyingthem usually requires more money than investing in single-familyhomes or smaller units. If additional capital is needed, consider form-ing a small group of active investors.

There are various entities available to group or gather investors. Someof the more familiar ones are limited partnerships, corporations, generalpartnerships, and real estate investment trusts. A relatively unknownform of ownership to effectively gather active investors is the tenants-in-common (TIC) form of ownership. It’s an easy, low-cost method of fund-ing real estate investments while maintaining tax benefits.

OWNERSHIP FEATURES THAT PROVIDE FLEXIBILITY

Tenants-in-common is a form of ownership that may involve two ormore people, and it does not require a marital relationship. With atenants-in-common ownership:

c13.qxd 4/5/04 11:39 AM Page 177

178 TENANTS-IN-COMMON FORM OF OWNERSHIP

1. There can be two or more co-owners, but their ownership inter-ests need not be equal. For example, if three people are co-owners,one could have a share of 25 percent, another 30 percent, and thethird 45 percent.

2. There is no automatic right of survivorship. Unlike joint tenancy,a share in the property held by one owner does not automaticallypass to the other owners at death. When a tenants-in-commonowner dies, that owner’s interest is transferred to his or her heirsand not to the other tenants-in-common, unless there’s an agree-ment giving title to the co-owners.

3. Interest held by tenants-in-common may be sold separately by in-dividual owners. In many cases, when tenants-in-common firstacquire the property, they agree to give the other co-owners a“first right of refusal” to buy out one another.

WAYS TO SAVE WITH A TENANTS-IN-COMMONOWNERSHIP

Here are seven advantages of the tenants-in-common ownership overother entities:

1. Low set-up costs: Compared to other forms of ownership, tenants-in-common has one of the lowest set-up costs. You don’t need an attor-ney to prepare offering circulars or registration with governmentalagencies. In fact, all that is required is to have the names of the ownersrecorded when the transaction closes. A formal document is not neces-sary, though we would recommend one. Accounting fees for preparingpartnership, trusts, and corporation returns are eliminated as well asstate and federal income taxes.

2. Low down payment: In some public offerings, restrictions are im-posed on the use of leverage. Using the tenants-in-common form of own-ership, there are none. This is an important investment strategy inpurchasing and selling midsize apartment complexes. The lower thedown payment, the more leverage, and the more property you can control.

3. Active voice in management: An important investment goal is to re-duce taxes. The tenants-in-common form of ownership does this by al-lowing an active voice in management. Tenants-in-common owners,with the help of qualified consultants, are extremely effective in mak-ing the right decisions. The old adage “two heads are better than one”hits the bull’s-eye, especially when these heads are concentrating on be-coming wealthy.

c13.qxd 4/5/04 11:39 AM Page 178

WAYS TO SAVE 179

4. Ease of transferability: Unlike a certification of ownership in a part-nership, the tenants-in-common ownership has a greater degree oftransferability. Each owner’s name is on the deed and is recorded. Anowner’s interest can be sold, hypothecated, willed, or transferred with-out the consent of the other co-owners, and each owner has completecontrol of his or her interest. In evaluating collateral, lenders generallygive more credence to an interest in a recorded tenants-in-common in-terest than in a limited partnership.

5. Economy of scale: Because investment dollars are being accumu-lated by a group, there are more dollars available to purchase largerproperties. Many individual investors don’t have the opportunity to use the economies of scale unless they form a group. How does thisconcept apply to apartment complexes? If one unit is vacant in a four-unit complex, what would the vacancy factor be? If you said 25 percent,you are correct. On the other hand, if one unit is vacant in a 40-unitcomplex, what would that vacancy factor be? Right, 2.5 percent.

Just think about it! When the carpet layer is called, to whom doyou think the better square-foot price will be given, the owner of the40-unit building or the four-unit building. The same applies to allvendors.

6. No mortgage or qualifying restrictions: Unlike most public limitedpartnerships, tenants-in-common ownership doesn’t have any restric-tions for financing or investor qualifications. Financing can be struc-tured to give the greatest flexibility to each individual owner either atthe time of purchase or sale. The group is formed based on the needsand desires of its members not on standards imposed by governmentalagencies. Individual owners don’t need a minimum or maximum networth to invest. They’re not required to have someone attest to their ca-pability of making their own investment decisions. Nor are they forcedto have experts make these decisions for them.

7. Tax advantages: Using the tenants-in-common form of ownership,gives you the opportunity to become an active investor. As such, youcan qualify for the $25,000 per year write-off against your salary, divi-dends, interest, and other income. This form of ownership provides theflexibility needed to implement the tax-saving strategies discussed ear-lier. Other forms of ownership satisfying only passive investor require-ments do not have these capabilities.

8. Neither a real estate nor a securities license is required to form aprivate tenants-in-common group to invest in real estate. If you do notmanage or control the group, it doesn’t have to be registered or quali-fied with any governmental agency as a security.

c13.qxd 4/5/04 11:39 AM Page 179


TAX IMPACT OF TENANTS-IN-COMMON OWNERSHIP

Deferred income on recognition of taxable gain when selling rentalproperty (the Internal Revenue code section 1031) mandates that thetenant-in-common co-ownership must meet these four requirements:

1. To form a tenants-in-common group, each of the co-owners musthold interest as tenants-in-common. No one can previously haveheld interest in property in any other legal entity (for examplepartnership).

2. The allocation of income and expenses as well as liability for blan-ket and encumbrance shall be in accordance with the co-ownerspercentage interest and ownership interest.

3. All of the co-owners of the entity must have the right to vote onall issues of the ownership. An owner or sponsor or manager mayadvance funds to cover payments due from another co-owner.This debt is recourse and must be paid within 31 days.

4. There is an exit requirement that each co-owner retains a right totransfer, petition, or encumber their ownership interest.

New Guidelines for Tenants-in-Common Interest

Procedure 2022-22 provides guidelines in the use of fractional interest inthe replacement properties in the 1031 exchange. The key criteria are:

1. The number of tenants-in-common cannot exceed 35.2. The sponsor of interest may own the property or an interest there

for only 6 months before 100 percent of the interest can be sold.3. Any decision has a material impact on the property owners must

be approved unanimously by the owners.4. The management agreement must be renewed annually and must

provide for market rate compensation.

THE NUMBER ONE PITFALL OFSECURITY TRANSACTIONS

Simply stated, if you control a group and the outcome of the invest-ment, you, in effect, have created a security transaction. This meansthat you cannot publicly advertise for investors unless it ’s properlyregistered. The cost and time involved for most people to register theiroffering is prohibitive. Not being able to advertise freely can be a se-vere handicap. So, where do you find investors? Your best source for

c13.qxd 4/5/04 11:39 AM Page 180

CREATING A NONSECURITY TRANSACTION 181

potential investors is relatives, friends, associates, and clients. Rela-tives, who know you personally, are more likely to entrust their moneywith you rather than a stranger. People who know you—those who arefamiliar with your background and who can count on you to do thebest job for them.

Family relationships sometimes get strained in these matters. It isimportant to evaluate kinships. The last thing you want is a family dis-pute over investments. However, if relatives insist on becoming part ofyour group, have each one sign a statement acknowledging the risks.Have your attorney prepare this document.

Ideally, you should have compatible investors in your group whohave had previous diversified investment experience and fall withinthe wealth-building period on the chronological time line.

As an additional precaution, have the investor’s qualified represen-tative review all the information pertaining to the investment andcomplete a Purchaser’s Representative Questionnaire (Figure 13.1).This independent third party, in effect, determines the merits of the in-vestment for the investor.

If you don’t have any qualified relatives or personal or business con-tacts, how do you find prospective investors? It’s very hard to do be-cause of the restrictions on public advertising. The only way to advertiseis to have a registered public offering or a nonsecurity transaction. Theregistered public offering is terribly expensive. The nonsecurity transac-tion won’t cost you a thing.

CREATING A NONSECURITY TRANSACTION

When putting a group together, it is important to determine whetherit’s a security or a nonsecurity, as defined by both the Howey Test (seeSEC v. Howey [1946] 328 U.S. 293) and the Risk Capital Test (see SilverHills Country Club v. Sobieski [1961] 55 Cal. 2d 811). If the transactionssatisfy either test, it will be classified as a security (see People v. Schock[1984] 152 Cal. App. 3rd 379) and you would not be permitted to pub-licly advertise for investors.

Howey Test

The Howey court case established the definition of a security. It states,“If the scheme involves an investment of money in a common enterprisewith profits to come solely from the efforts of others” a securities exist.Whether the profits are said to come “solely from the efforts of others”has been interpreted to mean, “whether the efforts made by those other

c13.qxd 4/5/04 11:39 AM Page 181

182

Dear Sir or Madam:

The information contained herein is being furnished to you in order for youto determine whether a sale of an interest in certain real property commonlyreferred to as maybe made to the following prospective Purchaser

(insert name of prospective Purchaser)

in light of the requirements of Section 4 (2) of the Securities Act of 1933, asamended (the “Act ”), and Regulation D and state securities laws. The under-signed understands that (a) you will rely upon the information contained hereinfor purposes of such determination, (b) the interest will not be registered orqualified under the Act in reliance upon the exemption from registrationafforded by Section 4 (2) of the Act as explained in Regulation D, (c) the inter-est will not be registered or qualified under any state securities laws, and (d)this questionnaire is not an offer to sell the interest or any other securities tothe undersigned Purchaser Representative.

I note that you have provided the above-named Purchaser with disclosurematerials prepared by

(your firm’s name)

It should be noted by you that nothing herein shall be construed as a repre-sentation by me that I have attempted to verify this information.

RATHER, TO THE CONTRAY, THE SCOPE OF MY ENGAGEMENT BY, ANDMY DISCUSSION WITH, THE ABOVE-NAMED PURCHASER HAVE BEEN LIM-ITED TO A DETERMINATION OF THE SUITABILITY OF AN INVESTMENT BYTHE ABOVE-NAMED PURCHASER IN LIGHT OF SUCH PURCHASER’S PRES-ENT INVESTMENT CIRCUMSTANCES, AS SUCH CIRCUMSTANCES HAVEBEEN PRESENTED TO ME. FOR THIS PURPOSE I HAVE ASSUMED, BUT DONOT IN ANY WAY REPRESENT OR WARRANT, EITHER TO YOU OR TO THEABOVE-NAMED PURCHASER, THAT THE INFORMATION IS ACCURATE ANDCOMPLETE IN ALL MATERIAL ASPECTS. EACH AND EVERY STATEMENTMADE BY ME IN THE FOLLOWING PARAGRAPHS ARE QUALIFIED BY REF-ERENCE TO THE FOREGOING.

With the above in mind, I herewith furnish you with the following information:(1) I have discussed the disclosure materials with the above-named Pur-

chaser with a view to determining whether an investment by such a Pur-chaser is not inappropriate in light of such Purchaser ’s financialcircumstances, as such circumstances have been disclosed to me by suchPurchaser.

(2) The undersigned is not an affiliate, director, of ficer, or other employee of


Figure 13.1 Purchaser’s representative questionnaire.

c13.qxd 4/5/04 11:39 AM Page 182

183

or beneficial owner of an equity interest in the property except as follows:(state “No Exceptions” or set forth exceptions and give details).

(3) The undersigned has such knowledge and experience in financial and busi-ness matters as to be capable of evaluating the merits and risks of thisinvestment. The undersigned offers as evidence thereof the following addi-tional information (for example, investment experience, business experi-ence, profession, education):

(4) There is no material relationship between me or my affiliates and


or its af filiates that now exists, is mutually understood to be contemplated,or which has existed at any time during the previous two years, nor hascompensation been received or will be received as a result of any suchrelationship, except as follows:

(NO EXCEPTIONS PERMITTED)

The undersigned agrees to notify you promptly of any changes to the infor-mation described in this questionnaire that may occur prior to the comple-tion of the transaction.

Very truly yours,

Dated: Print or type name of Purchaser ’s Representative

Purchaser ’s Representative’s Signature

Street Address

City and State

Telephone


c13.qxd 4/5/04 11:39 AM Page 183


than the investor(s) are undeniably significant ones, those essentialmanagerial efforts that affect the failure or success of the enterprise.”

If it is determined that the profits were made by undeniably signifi-cant and essential managerial efforts of everyone in the group (activeparticipation), and not others, then the investment would not be consid-ered a security. Therefore, the restriction on advertising wouldn’t apply.

Risk Capital Test

Under the Risk Capital Test, the court will be looking to determine:(1) whether funds are being raised for a business venture or enterprise;(2) whether the transaction is offered indiscriminately to the public atlarge; (3) whether the investors are substantially powerless to effect thesuccess of the enterprise; and (4) whether the investor’s money is sub-stantially at risk because it is inadequately secured.

Establishing suitability requirements of potential co-owners shouldnot be construed as an “indiscriminate” offering. Further, co-owners re-tain control over the success of their investment. In this, they are not“powerless” as such. Finally, it may be argued that the fair market valueof the investment, based on its potential income production, is at leastequal to the purchase price as a determinant of whether a co-owner’s in-vestment is inadequately secured (Leyva v. Superior Court [1985] 164 Cal.App. 3d 462).

The March 1989 issue of California Business Law Reporter, Volume X,Number 6, “Terms of Partnership Agreement Determine Whether Gen-eral Partnership Interest Is a Security,” written by David M. Greenberg,provided by the 1989–1990 Regents of the University of California Con-tinuing Education of the Bar’s California Business Law Reporter, elaboratesfurther on this issue.

Is a general partnership a security for purposes of the federal secu-rities law? Joining a debate that has led to differing views among thecircuit courts, the Ninth Circuit Court of Appeals decided that theissue is determined by examination of the general partnership agree-ment, as opposed to the manner in which the partnership functionedin carrying out its business affairs. (Matek v. Murat [9th Cir. 1988] 862F2d 720.) In reaching this conclusion, the court rejected the “bright-line” rule, which holds that a general partnership interest is not a security because of the broad management and control powers con-ferred on general partners by partnership law. (Goodwin v. Elkins & Co.[3rd Cir. 1984] 730 F2d 99.) The court also rejected the test fashioned inWilliamson v. Tucker [5th Cir. 1981] F2d 404 (dicta), which required “notsolely from the efforts of others.” (SEC v. W. J. Howey Co. [1946] 328 US

c13.qxd 4/5/04 11:39 AM Page 184

CREATING A NONSECURITY TRANSACTION 185

293, 301.) The Ninth Circuit has interpreted the word “solely” in theHowey test as requiring that the efforts of those other than the investor be “the undeniably significant one.” (SEC v. Glen W. Turner Enters., Inc. [9th Cir. 1973] 474 F2s 476, 482.) In determining whetherthe efforts of the plaintiffs in the fish-processing venture were the“undeniably significant ones,” the court of appeals in Matek rejectedboth the “bright-line” test of Goodwin and the postformation factualexamination required under Williamson. Instead, the court fashionedits own modified Williamson Test.

Williamson Test

EXAMINATION OF AGREEMENT The court held that only the firstprong of the Williamson Test should apply, that is, a determination ofwhether the partnership agreement left “so little power in the hands ofthe partners or ventures that the arrangement in fact distributes poweras would a limited partnership.” Applying this test to the partnershipagreement at issue in Matek, the court found that the agreement was a“standard general partnership contract.” The contract placed manage-rial control and access to partnership information in the hands of thegeneral partners. No partner could withdraw capital from the partner-ship without the consent of all partners, and no partner could lendmoney to the partnership without the approval of the majority of part-ners. Although the document called for the appointment of managingpartners with power to control the day-to-day business of the partner-ship, the managing partners were required to consult “as far as practi-cable” with the other partners about business decisions. Various actscould be done only with the consent of the majority of partners, includ-ing the borrowing of money, the transferring or hypothecating of part-nership claims, and the sale of partnership property other than theordinary course of business. Partnership interests were not freelytransferable (admission of new partners required the agreement of amajority of partners), and the agreement could be amended only withthe approval of all partners. Finally, the books of the partnership wereopen for inspection to all partners.

The court added that plaintiffs had “made no showing and are unableto show that they were prevented from exercising their powers underthe agreement,” and further noted that “there is no evidence that thegeneral partnership agreement was purposely drafted to escape the ap-plication of securities laws” (862 F2d at 731). Because of the foregoingfeatures of the partnership agreement, the court concluded that theventure was controlled by the plaintiffs, and not by “others.” According

c13.qxd 4/5/04 11:39 AM Page 185


to the court, the general partnership agreement provided the partners,including the plaintiffs, with access to information and the ability toprotect their investment that the securities laws would otherwise pro-vide. The agreement created powers and duties in the general partnersthat were not typical of passive investors in a security. Accordingly, thegeneral partnership interests were not investment contracts for pur-poses of the definition of a security under the federal securities laws.

CONCURRING OPINION In a concurring opinion, the court agreedwith the rejection of the “bright-line rule,” but favored adopting theWilliamson Test and looking beyond the terms of the general partnershipagreement in determining whether, as an “economic reality,” a generalpartnership interest is a security. The court acknowledged that an in-vestor claiming that a general partnership interest is a security has adifficult burden. In meeting that burden, a plaintiff should be allowedto introduce facts extrinsic to the partnership agreement. However, thecourt agreed with the majority opinion because plaintiffs failed to sat-isfy the Williamson factors.

COMMENTS The court’s decision in Matek is a welcome developmentfor attorneys drafting general partnership agreements. The court’s ref-erence to a “standard” general partnership that is not a security, is help-ful to practitioners. It is significant that the court reached its conclusionin Matek despite a provision vesting day-to-day control in managing gen-eral partners who were required to consult with the other partners onbusiness decisions only “as far as practicable.” As long as general part-nerships are not drafted to evade the securities laws, counsel should feelconfident that a general partnership interest will not be held to be a se-curity. Establishing a group of investors to attain all the benefits de-scribed herein (including tax benefits) constitutes a legitimate reasonfor drafting a tenants-in-common agreement.

A NOVEL WAY TO MARKET A NONSECURITY

How can a marketing program be implemented to form a group of in-vestors without running afoul of the securities laws? In order to accom-plish this, you must demonstrate that you’re offering professionalconsulting services. Offer advice, not control. A marketing plan that isdesigned to accomplish this objective would include your advertisingpublicly in the newspaper, on television, through direct mail, or throughany other media for a “paid” educational seminar. For the best response,place your advertisements two weeks in advance of the actual date of theseminar—with at least two exposures. If you have books, audio and

c13.qxd 4/5/04 11:39 AM Page 186

A NOVEL WAY TO MARKET A NONSECURITY 187

video tapes on related subjects, or if you are trying to get clients for yourconsulting services, you might want to make it a free seminar. Remem-ber, never advertise for investors!

Diligently prepare a meaningful, informative, and educational pro-gram, and present it in a skillful manner. Having it approved for con-tinuing education credits by the related professional organizationswill help in the marketing.

The best time to conduct seminars is either midweek in the eveningsor on a Saturday morning. Keep it under three hours, allowing time forquestions and answers. Provide refreshments. Use an overhead projec-tor to make visual presentations.

During the meeting distribute a Seminar Evaluation form (Fig-ure 13.2).

How to Tap an Unlimited Supply of Buyers

Using the seminar, you will be able to tap into the pool of people whoare interested in being informed of future real estate opportunities.You can send property set-up sheets and make property presentations.Also, you will be able to offer your professional services in locatingareas of opportunity and analyzing properties.

If a number of people are interested in a particular property, a tenant-in-common investment group should be formed (not under your con-trol), to make an offer either to you or through you, if properly licensed.

If you are not a real estate licensee and you simply want to sell yourposition in the property rather than being part of the group, you canlegally do so by using the techniques described earlier. In this particu-lar case, not having a real estate license could work to your advantagebecause of various disclosure laws.

Protect Yourself When Dealing with Nonsecurity Transactions

To strengthen your position that the transaction is not a security, takeonly a minority interest in the group. Be sure the group maintains con-trol of the outcome of the investment—not you. All decisions must bestrictly those of the group. Make the tenants-in-common group awarethat, under no circumstances, are you allowed to manage its affairs. Ifyou do, you could be considered a promoter, subjecting the entiretransaction to security laws, giving each investor a built-in insurancepolicy against all losses they may incur if the investment goes belly up.

If you enter into a real estate consultant agreement (see sample formin Chapter 4, Figure 4.3), limit your activities to those performed by areal estate licensee, not a managing general partner.

c13.qxd 4/5/04 11:39 AM Page 187

188

Seminar Evaluation

WELCOME . . . Please take a few minutes to fill out the information requestedon this card. We will collect the cards as you are leaving the seminar. Thankyou for your help!

Name Date

Address Daytime Phone

City Evening Phone

State Zip

How did you hear about us?

(circle)I’d like to receive information on future Real Estate Opportunities YES NOPlease circle one for each question:

The speaker was informative.Strongly Agree Agree Strongly Disagree

The material was presented in an interesting way.Strongly Agree Agree Strongly Disagree

What information could be made more clear?

How can we improve this seminar?

Thanks again for your help!

1. Major Newspaper2. Local Newspaper3. T.V.4. Radio5. Mailing6. Friend or Relative7. Stock Broker

8. Realtor9. CPA

10. Attorney11. Financial Planner12. Insurance Agent13. Other

Figure 13.2 Seminar evaluation. Source: The Center for Real Estate Studies.

c13.qxd 4/5/04 11:39 AM Page 188

SUMMARY 189

PARTICIPATING IN PROFITS WITHOUT OWNERSHIP

If ownership is not in your plans but you still want to participate in po-tential profits, sell the property to the tenants-in-common group, andtake back a participating note and deed of trust on the property. As anoffset, offer a below-market interest rate and/or accruals. By taking thisapproach, not only will you save significantly on taxes, but you will alsobe making a statement to the buyers of your faith in the property.

With the help of one of the nation’s largest accounting firms, we de-veloped a tenants-in-common agreement to protect the individual co-owner’s interest as well as their tax benefits. It is designed to meet therequirements of active participation. It can be used for both securityand nonsecurity type transactions. This agreement is made availableby The Center for Real Estate Studies (see page 226).

SUMMARY

There are definite advantages to group ownership. Probably the mostprevalent is economy of scale. The tenants-in-common form of owner-ship provides a simple, low-cost way for investors to form groups,while maintaining many tax benefits.

Depending on your preference, the tenants-in-common group can beformed as a security or a nonsecurity. If classified as a security, no pub-lic advertising is permitted unless it is registered as a public offering.Conducting nonsecurity transactions is relatively easy and inexpensive.

If a co-ownership group is being formed as a nonsecurity, don’tjeopardize your position by acting as a promoter or general partner. Bydoing so, you’ll be indemnifying its members against all losses.

c13.qxd 4/5/04 11:39 AM Page 189

c13.qxd 4/5/04 11:39 AM Page 190

191

14Gain Freedomfrom Lawsuits

PAINTING A TRUE PICTURE OF LITIGATION

In my attorney’s office hangs a picture depicting a farm scene enti-tled “Litigation.” In the middle of the picture is a drawing of a cow.At one end of the cow is a very angry man gripping the cow’s hornsand trying to pull the cow toward him. His caption reads, “The Plain-tiff.” At the other end is another very angry man tugging on thecow’s tail trying to move the cow in his direction. His caption reads,“The Defendant.” In the middle, sitting on a stool, is a well-dressedman with a big smile on his face, milking the cow. His caption reads,“The Attorney.” And so it goes!

Unfortunately, litigation has become a way of life in this country.Both time and money are lost because of this national pastime. Thereare over 16 million lawsuits filed each year in this country. More than70 percent of the attorneys in the world live in the United States. It’sno wonder that our legal system is in such a mess.

There are two unique aspects of the U.S. system that are alleged toencourage frivolous lawsuits and out-of-court settlements. First is thecontingency fee arrangement with attorneys. This is when attorneys are

192 GAIN FREEDOM FROM LAWSUITS

compensated only if they win. In other words, a person can sue withouthaving to pay any attorney fees up front. Defendants, of course, have nosuch privilege.

Then there is the “one-way” fee system, which means the plaintiff col-lects costs and fees from the defendant if the plaintiff wins. A successfuldefendant receives nothing. Defending a case can cost thousands of dol-lars. Regardless of its merits, defendants will usually end up making abusiness decision and will settle the suit out of court.

A movement requiring disputing parties to arbitrate their disputes iswinding its way through the legal system. I hope it takes hold and issoon adopted by the entire legal profession. Arbitration generally costsless, is quicker, and it is not as likely to cause the major disturbancesbrought by lengthy court trials. An experienced judge hears the factsand, based on a legal interpretation of the law, makes a decision. Thejudge doesn’t get involved emotionally, and the decision is based on thejudge’s comprehensive knowledge of the law. Because arbitration tendsto reduce attorney fees, the movement is slow in coming. In the interim,you must take measures to protect yourself and your assets.

PROTECTING YOURSELF FROM LAWSUITS

The best safeguard is not to have any attachable assets. This can be ac-complished by creating an estate plan that transfers all your assets intoa family-limited partnership. It’s best to make the transfer before thethreat of a lawsuit and/or actual judgment is rendered against you. Ifyou wait, the transfer might be considered a fraudulent conveyance ofproperty. However, transfers made after can also afford a powerful de-gree of safety.

Warning Signs of a Fraudulent Conveyance

Fraudulent conveyance is determined on a case-by-case basis by thecourts. The following represents some of the warning signs when mak-ing that judgment:

1. Consideration paid2. Solvency of a debtor before and after transfer3. Pending claims at the time of transfer4. Intent of the debtor

If a judgment creditor proves that the transfer was fraudulent, a levycan be placed on the property transferred and the creditor can proceedagainst the debtor as if the transfer had never been made.

PROTECTING YOURSELF FROM LAWSUITS 193

Avoiding Fraudulent Conveyance

Debtors who transfer assets without receiving reasonable value in ex-change subject the transaction to either the Uniform Fraudulent Con-veyance Act (UFCA) or the Uniform Fraudulent Transfers Act (UFTA). Ifyou transfer assets into a family-limited partnership (FLP) as part of anestate plan, and you receive limited partnership interest of equal value,then you’ve, in effect, complied with the “fair value” section of this act.

The transfers of assets into the FLP does not create insolvency be-cause, as a limited partner, you retain an interest in the partnership.This interest has value because the partnership has value. Both youand the partnership are solvent, before and after the transfer; thereby,conforming with the “solvency” test of both UFCA and UFTA.

If a transfer is made because of probable liability as a result of pend-ing lawsuits, a court could find the transfer fraudulent. However, if itcan be proven that the claim was merely possible and not probable, thetransfer would not be considered fraudulent. Generalized complaintsfrom clients about the quality of goods or services should not be consid-ered probable causes for liability.

Making Yourself Judgment Proof

Can future creditors challenge transfers of property when the transferoccurred prior to the date of the creditor’s claim? As to future credi-tors, the courts have consistently held that future creditor’s rights arelimited. Representative cases are as follows:

Hurlbert vs. Shackleton, 560 S. 2d. 176, June 1, 1990. The court drew adistinction between “probable” and “possible” future creditors. Thecourt said it found no cases holding a transfer of assets to be fraudu-lent as to “possible” future creditors. At the time of the conveyance,there must be evidence establishing actual fraudulent intent by onewho seeks to have the transaction set aside. A transfer of propertyby a debtor is not fraudulent unless the act is directed against credi-tors who have just, lawful, and existing claims. Even if the debtor in-tends to deceive the public, if the act in transferring the propertydoes not hinder or delay the creditors, no legal fraud exists.

Transfers of assets (or liabilities incurred) with the actual intentto hinder, delay, or defraud a present or future creditor can be setaside as a fraudulent conveyance. If the intent is to create both an es-tate and a tax plan, then it would not run the risk of being a fraudu-lent transfer. Whether a transfer was in contemplation of a creditor’sclaim is an important point in a fraudulent conveyance claim. The


transfer of assets for legitimate estate tax planning, business, or in-vestment purposes complies with the “intent” portion of both theUFCA and UFTA.Re Oberst, 91 Bankr. 97, C.D. Cal. 1988. The court regarding the ques-tion of denial of discharge stated that Congress has decided that thekey is the intent of the debtor. If the debtor has a particular creditor(s)in mind and is trying to remove assets from the creditor(s) reach,there are grounds to deny discharge. But, if the debtor is merely look-ing for his or her future well being, the discharge will be granted.Horbach vs. Hill, 112 U.S. 144. The U.S. Supreme Court stated that theone who was not a creditor of the grantor at the time a deed was ex-ecuted cannot complain of its fraudulent execution.

Never get involved in any conspiracy to conceal assets from creditors.Fraudulent conveyances fall under civil codes, and intentional conceal-ment is criminal. There is a fine line between legitimate asset protectionand asset concealment. In creating business and estate planning, negateinference of fraudulent intent by properly documenting all transfers. Al-ways time the transfers to correspond to justifiable reasons.

THE UNIFORM FRAUDULENT CONVEYANCE ACT

SECTION 1. DEFINITION OF TERMS In this act “assets” of a debtormeans property not exempt from liability for debts. To the extent thatany property is liable for any debts of the debtor, such property shallbe included in the debtor’s assets. “Conveyance” includes every pay-ment of money, assignment, release, transfer, lease, mortgage, or pledgeof tangible or intangible property, and also the creation of any lien orencumbrance.

“Creditor” is a person having any claim, whether matured or unma-tured, liquidated or unliquidated, absolute, fixed, or contingent.

“Debt” includes any legal liability, whether matured or unmatured,liquidated or unliquidated, absolute, fixed, or contingent.

SECTION 2. INSOLVENCY

1. A person is insolvent when the present fair salable value of assetsis less than the amount that will be required to pay probable lia-bility on existing debts as they become absolute and matured.

2. In determining whether a partnership is insolvent, there shall beadded to the partnership property the present fair salable valueof the separate assets of each general partner in excess of the

THE UNIFORM FRAUDULENT CONVEYANCE ACT 195

amount probably sufficient to meet the claims of separate credi-tors, and also the amount of any unpaid subscription to the part-nership of each limited partner, provided the present fair salablevalue of the assets of such limited partner is probably sufficientto pay the debts, including such unpaid subscription.

SECTION 3. FAIR CONSIDERATION Fair consideration is given forproperty, or obligation.

1. When, in exchange for such property, or obligation, as fair equiv-alent therefor, and in good faith, property is conveyed or previ-ous debt is satisfied, or,

2. When such property, or obligation is received in good faith to se-cure a present advance or antecedent debt in an amount not dis-proportionately small as compared with the value of the property,or obligation obtained.

SECTION 4. CONVEYANCES BY INSOLVENT Every conveyancemade and every obligation incurred by a person who is or will bethereby rendered insolvent is fraudulent as to creditors without re-gard to the person’s actual intent, if the conveyance is made or the ob-ligation is incurred without a fair consideration.

SECTION 5. CONVEYANCES BY PERSONS IN BUSINESS Every con-veyance made without fair consideration when the person making it isengaged or is about to engage in a business or transaction for which theproperty remaining in the person’s hands after the conveyance is anunreasonable small capital, is fraudulent as to creditors and as to otherpersons who become creditors during the continuance of such businessor transaction without regard to the person’s actual intent.

SECTION 6. CONVEYANCE BY A PERSON ABOUT TO INCUR DEBTSEvery conveyance made and every obligation incurred with actual in-tent, as distinguished from intent presumed in law, to hinder, delay, ordefraud either present or future creditors, is fraudulent as to both pres-ent and future creditors.

SECTION 8. CONVEYANCE OF PARTNERSHIP PROPERTY Everyconveyance of partnership property and every partnership obligationincurred when the partnership is or will be thereby rendered insol-vent, is fraudulent as to partnership creditors, if the conveyance ismade or obligation is incurred


1. To a partner, whether with or without a promise to pay partner-ship debts,

or

2. To a person (not a partner) without fair consideration to the part-nership as distinguished from consideration to the individualpartners.

SECTION 9. RIGHTS OF CREDITORS WHOSE CLAIMSHAVE MATURED

1. Where a conveyance or obligation is fraudulent as to a creditor,such creditor, when the claim has matured, may, as against anyperson except a purchaser for fair consideration without knowl-edge of the fraud at the time of the purchase, or one who has de-rived title immediately from such a purchaser,a. Have the conveyance set aside or obligation annulled to the ex-

tent necessary to satisfy the claim,

or

b. Disregard the conveyance and attach or levy execution uponthe property conveyed.

2. A purchaser who without actual fraudulent intent has given lessthan a fair consideration for the conveyance or obligation, may re-tain the property or obligation as security for repayment.

SECTION 10. RIGHTS OF CREDITORS WHOSE CLAIMS HAVE NOTMATURED Where a conveyance made or obligation incurred isfraudulent as to a creditor whose claim has not matured, the creditormay proceed in a court of competent jurisdiction against any personagainst whom he or she could have proceeded had the claim matured,and the court may,

1. Restrain the defendant from disposing of the property,2. Appoint a receiver to take charge of the property,3. Set aside the conveyance or annul the obligation, or,4. Make any order that the circumstances of the case may require.

SECTION 11. CASES NOT PROVIDED FOR IN ACT In any case notprovided for in the act, the rule of law and equity, including the lawmerchant, and in particular the rules relating to the law of principaland agent, and the effect of fraud, misrepresentation, duress or coer-cion, mistake, bankruptcy, or other invalidating cause, shall govern.

LEGAL BASIS FOR FAMILY-LIMITED PARTNERSHIP 197

SECTION 12. CONSTRUCTION OF ACT This act shall be so inter-preted and construed as to effectuate its general purpose to make uni-form the law of those states that enact it.

SECTION 13. NAME OF ACT This act may be cited as the UniformFraudulent Conveyance Act.

SECTION 14. INCONSISTENT LEGISLATION REPEALED Sectionsare hereby repealed, and all acts or parts of acts inconsistent

with this act are hereby repealed.

LIMITED LIABILITY COMPANIES

Limited liability companies (LLCs) are entities formed to protect theowners personal assets from the risks of owning real estate. Thesecombine the liability protection of a corporation and the flexibility andtax benefits of a partnership. LLCs are the answer to the legal goals ofreal estate investing today because they provide the basic advantagesof corporations and limited partnerships with few requirements andvery little paperwork.

LLCs can be used for estate planning and to clarify managementstructure. When you form an LLC, you take advantage of anonymity.The documents in a public LLC require very little personal information.LLCs can be used for 1031 exchanges also. For example, if five investorsown property under a TIC form of ownership and want to exchange it,they can form five separate LLCs and still meet the requirements for1031 exchange.

Estate planning using an LLC can save a great deal of money. Basedon evaluation, no one can argue that $50,000 in cash is worth $50,000.But what is the value of $50,000 interest or a 10 percent interest in anLLC? Because the value of an LLC is less marketable than $50,000 incash, the IRS tends to allow discounts on the evaluation in an intereston an LLC thereby reducing the estate taxes.

THE LEGAL BASIS FOR THEFAMILY-LIMITED PARTNERSHIP

How will the transfer of assets into a FLP protect those assets? Theanswer lies in the California court ruling in Centurion Corp. v. CrockerNat ’l Bank (1989) 208 Cal. 3d 1, 255 CR 794. The 1989/1990 The Re-gents of the University of California Continuing Education of theBar’s California Business Law Reporter printed this article in Volume X,


Number 8 ( June 1989) publication, written by David M. Greenberg. Asynopsis of the case is as follows:

In an apparent case of first impression, the First District Court of Ap-peals has held that a limited partnership interest may be sold at anexecution sale at the request of a limited partner’s judgment creditor. InCenturion Corp. v. Crocker Nat ’l Bank (1989) 208 Cal. 3d 1, 255 CR 794,Crocker National Bank obtained a judgment for more than $1 millionagainst the defendant, the only limited partner in a partnership knownas Turn-Key Storage. The defendant’s mother was the sole general part-ner in Turn-Key. The bank received no funds as a result of its chargingorder, and moved for an order to sell the defendant’s limited partner-ship interest. The defendant received notice at a federal prison, where hewas a prisoner. His mother filed a statement of nonopposition to thesale, stating that the partnership had no objections, provided that, incompliance with the partnership agreement, the purchaser would havethe right to receive profits and losses only, but not to become as substi-tuted limited partner. The trial court issued an order permitting thesale. The court of appeals affirmed. The court reviewed long-standingCalifornia statutory law that prevents a partner’s judgment creditorfrom executing on partnership assets or directly on a partner’s interestin the partnership. Rather, a judgment creditor is first required to seek acharging order to reach the debtor partner’s interest in the partnership.The California Uniform Partnership Act, the Uniform Limited Partner-ship Act, and the Revised Limited Partnership Act each provide for thischarging order procedure. (See Corp C 15028, 15522, 15673.) Thus, forexample, Corp C 15673 provides as follows:

On application to a court of competent jurisdiction by any judgmentcreditor of a partner, the court may charge the limited partnership in-terest of the partner with payment of the unsatisfied amount of thejudgment with interest. To the extent so charged, the judgment creditorhas only the rights of an assignee of the limited partnership interest.This chapter does not deprive the partner of the benefit of any exemp-tion laws applicable to the partner’s limited partnership interest.

The defendant did not appeal the validity of the charging order. Heargued that the trial could not order his limited partnership interestsold at an execution sale. The court looked to the relevant statutorylanguage, as well as to statements in previous cases, and held for thefirst time that a court may authorize the sale of a judgment debtor’spartnership interest, when three conditions have been met: (1) thejudgment creditor has obtained a charging order; (2) the judgment

LEGAL BASIS FOR FAMILY-LIMITED PARTNERSHIP 199

remains unsatisfied; and (3) all partners other than the debtor haveconsented to the sale of the interest. According to the court, allowingan execution sale under these conditions will prevent the sale from dis-rupting partnership business, but will also prevent a debtor’s use ofpartnership law to foil judgment creditors when no legitimate interestof the partnership or the remaining partners would be served.

The defendant argued that the execution sale order was improper be-cause it was not consistent with Turn-Key’s limited partnership agree-ment. Under the agreement, the defendant had a 50-percent interest inprofits and losses, but not direct interest in partnership real or personalproperty. Also, as a limited partner, the defendant could not be active inmanagement and could not sell his interest in the partnership. The courtacknowledged both that a charging order cannot grant a creditor agreater interest in the partnership than the debtor had at the time of theorder, and that an order for sale cannot allow the purchases to acquiremore rights in the partnership than the debtor partner possessed. Thecourt held that the execution sale of the defendant’s interest did not con-stitute an order to sell property owned by the partnership. Rather, theexecution sale order required the sale of whatever interest the defendantheld in the limited partnership by reason of his being a limited partner.The purchaser at the execution sale could not become a substituted lim-ited partner without the further consent of the general partners. All ofthis was consistent with the limited partnership agreement.

COMMENT: PARTNER’S CONSENT The court did not discuss why itbelieved the consent of all partners other than the judgment debtor wasrequired to allow an execution sale. In Centurion, the defendant wasthe sole limited partner and the sole general partner consented to thesale. Thus, there was no problem in satisfying the unanimity require-ment. However, in many partnerships, it is difficult to achieve unanim-ity on such matters. Any of the other partners will be able to prevent ajudgment creditor from executing on the debtor’s limited partnershipinterest.

Most limited partnership agreements provide that the purchaser ofa limited partnership interest has only the rights of an assignee untilthe purchaser becomes a substituted limited partner with the consentof the general partner. Because of these limitations, the assignee can-not interfere with the operation of the partnership. Generally, the con-sent of the other limited partners is not required for an assignment.Consequently, there is no apparent reason for requiring approval of alllimited partners when a creditor seeks an execution sale of a limitedpartnership interest.


Many limited partnership agreements drafted under the CaliforniaRevised Limited Partnership Act limit the voting rights of limitedpartners in order to avoid the default voting provisions of that act oth-erwise available under Corp C 1536 (f) and 15632 (b) (5). If the partner-ship agreement does not provide specifically for limited partners tovote on an execution sale, it may be necessary to obtain a court order orto amend the partnership agreement in order to authorize the vote.

Most limited partnership agreements require the consent of the gen-eral partner to the admission of a substituted limited partner. If thegeneral partner consented to the execution sale, but refused further toconsent to the purchaser’s admission as a substituted limited partner,the judgment creditor would have no voting rights and would not beentitled to the other rights given to limited partners under partnershiplaw and most partnership agreements.

In any event, from a creditor’s standpoint, an execution sale may pro-vide limited assistance, especially when the creditor is the purchaser atthe sale.

RESTRICTION IN PARTNERSHIP AGREEMENT One issue raised butnot decided by Centurion is the validity of a provision in a partnershipagreement stating that a limited partnership interest cannot be trans-ferred pursuant to an execution sale order. The court indicated thatsuch a provision probably would not be enforceable, citing Tupper v. Kroc(Nev 1972) 491 P2d 1275, 1280, which held that a partnership agreementcould not divest a court of its powers to charge and sell a partnershipinterest. A right of first refusal in a partnership agreement, however,might still be effective and would, at least, complicate the execution saleof a partnership interest.

HAMPERING CREDITORS

The key to hampering creditor’s action is the vote. If the family limitedpartnership is created whereby the judgment creditors, who becomeassignees of the debtor’s interest, cannot vote, the capacity to direct theactivities of the partnership is curtailed. Without this ability, they can-not disburse partnership assets to satisfy their claims.

Paying Yourself without Paying the Creditors

Judgment creditors can attach a limited partner’s interest in the part-nership and receive any disbursement made to that particular limitedpartner. However, if the partners decide not to make any disburse-ments, creditors receive absolutely nothing.

HAMPERING CREDITORS 201

The partnership may make loans to individual limited partners with-out making distributions or withdrawals. These loans are very difficultto attach. The partnership may decide to pay wages to the limited part-ner. If judgment creditors attach the limited partner’s wages, there aresevere limitations on the amounts they can take.

Eliminating or Reducing the Cost of PersonalLiability Insurance

By properly protecting your assets from creditors claims, you can ef-fectively reduce the cost of personal liability insurance. Only carry theminimum required by law. If not required by law, seriously considerwhy you’re carrying it in the first place. You can reduce expenses forpersonal liability insurance substantially or eliminate them entirelywhen your assets are adequately protected.

Stumbling Blocks of Creditors

The net effect of having your assets protected is to eliminate or reduceyour exposure. This is a valuable bargaining chip if you do decide tonegotiate claims. In most cases, you’ll find the plaintiff and his or herattorney most cooperative when the uphill battle becomes apparent, asthey try to reach your assets with absolutely no assurances of success.

A creditor attempting to go after a limited partner is in a dilemma.The creditor will have to decide whether or not to expend additionaltime and money overcoming the following formidable obstacles:

• Obtain judgment against the debtor• Prove that the creditor has an interest in the limited partnership• Have the court issue a charging order• Obtain appointment of a receiver• Apply for foreclosure• Attempt a forced sale (without the right of an accounting)• Secure judicial dissolution of the limited partnership• Upon dissolution, receive what is left after priority-paying claims

More often than not, the creditor ends up with a charging orderagainst the interest of the limited partner that can generally be dis-charged or settled for an inconsequential sum.

The charging order entitles the creditor to income or assets onlywhen they are distributed. Even if income is not distributed out of thepartnership, the creditor is still taxed on it because the creditor isnamed on the K-1 (partnership tax return). Since the creditor cannot


force the distribution of assets or income, the creditor may suffer nega-tive cash flow for several years from paying taxes on his or her share ofpartnership income that hasn’t been received.

Negotiating a Settlement

Once the creditors know the position they’re in, they will probablywant to settle their claims as soon as possible. Your goal is the opposite.If you decide to settle, use the following strategies:

• Start off with paying 10 percent of the amount due, and go up inincrements of 5 percent, if you feel it ’s appropriate.

• Extend the payments out as far as possible.• Don’t offer any collateral or cosigners.• If they want to charge interest, prime rate is okay.• Have them erase any negative marks on your credit rating.

Never forget to let your creditors know that, if you go into bank-ruptcy, they may wait several years for a very small part of the pro-ceeds without interest.

Protection from Creditors of a Family-Limited Partnership

The most significant advantage an FLP has over a revocable living trustis that assets are protected from creditor claims. This is not the case ina revocable living trust. Anyone who has a legal claim against you caneffectively satisfy that claim by penetrating the revocable trust and re-moving its assets. In an FLP, this cannot be done because you controlthe vote. In addition to the asset protection, the FLP can be used as partof your estate plan to avoid probate and estate taxes in the same man-ner as a revocable living trust.

Estate Planning

The FLP is an excellent mechanism for estate planning. It will giveyou the asset protection you need to reduce liability exposure andstop lawsuits. The Center for Continuing Real Estate Studies has de-veloped a comprehensive program to implement your own FLP (seepage 197).

If your attorney reviews the agreement, please keep in mind thatnew ideas which adversely affect anyone’s ability to generate income,tend to be discarded. The FLP is designed to curtail litigation. Select anexpert who has the expertise to properly counsel you in this area.


Protecting Yourself from Existing Claims

For additional protection from existing creditors, transfer domesticFLP assets into a foreign asset protection trust (APT). You’ll be allowedto maintain control of your assets in the United States and still shieldthem from existing lawsuits and creditors.

This is how it works. Foreign trust laws provide several advantagesover domestic trust laws, even though you have the right to revoke oramend the trust, dispose of its assets, appoint or remove trustees, or toretain a beneficial interest. If a debtor with existing creditors is notrendered insolvent with the transfer of assets to the trust, the debtor isprotected even if he or she subsequently becomes insolvent. If the cred-itor wishes to challenge the transfer, the creditor must do it in the ap-propriate foreign jurisdiction within a definite limited time period,typically two years, or the claim will lapse.

Because of the two-year statute of limitations it is advisable to domi-cile the APT in the Cook Islands (a self-governing territory under theprotection of New Zealand) (see Figure 14.1).

In 1989, they amended their International Trusts Act (ITA) to provideadditional protection for APTs. The Cook Islands offers flexible, com-mercially-oriented legislation; the ITA is at the same time soundly basedon legal concepts hundreds of years in the making. The amendment ad-dressed the issues of protecting trusts in the event of alleged fraudulentconveyance and matters relating to the establishment of a trust.

The value and effectiveness of this legislation has been confirmedby the fact that to date no action in a Cook Islands court has set asidean international trust or a transfer to an international trust, or resultedin any injunction being issued against an international trust or a settleror trustee of an international trust.

In addition, no action or judgment of a foreign court, in respect tobankruptcy or debt, has recognized or enforced against any interna-tional trust or persons and property associated with such trust.

In fact, the secure shielding of international trust under Cook Islandslaw has been widely acknowledged. Legal recognition of this protectionhas actually led to advantageous settlements with creditors.

Asset Protection Plan Using a Foreign Trust

STEP 1 Select a portion of your assets you want to isolate and protectfrom lawsuits and creditors. (See Figure 14.2.)

STEP 2 The partnership consists of yourself as the managing generalpartner and you and/or your family as the limited partners. As the

204

Advantages of Foreign Jurisdiction TrustCook Islands

The Cook Islands are one example of a foreign jurisdiction with more favorableasset-protection trust statutes. Highlights of the statutes are:

Cook Islands International Trust Act:

13A. Bankruptcy: International Trust (“IT”) not to be void or voidable in the eventof the set t lor ’s bankruptcy, notwithstanding any provisions of a set t lor ’sdomicile and notwithstanding that an IT is voluntary.

13B. Fraud: Where creditor proves an IT was set t led with principal intent to de-fraud that creditor and that such set t lement rendered the set t lor insolvent orwithout property then such set t lement is not void or voidable, but the IT is li-able to satisfy claims out of property which but for set t lement would havebeen available. In determining whether set t lement rendered set t lor insolvent,regard should be given to the fair market value of the property (not the sub-ject of the trust) immediately af ter set t lement took place.

3. IT not fraudulent as against a creditor where:(a) set t lement or disposition takes place af ter expiration of two years from

the time the creditor cause of action accrued and(b) then creditor fails to bring an action before the expiration of one year

from the date the assets are placed into the trust.4. IT not fraudulent as against a creditor where the set t lement took place before

the cause of action accrued or arose.5. Settlor does not have intent to defraud creditor imputed solely by reason that

he or she:(a) set t les an IT within two years from the date of cause of action accruing

or(b) the set t lor retained, possess or acquires power or benefits if specified at

(a)–(f) of 13 C (see infra.).7. The onus of proof of a set t lor ’s intent to defraud creditor under this section

lies with the creditor.13C. Retention of Control: An IT is not invalid by reason of the set t lor(s) retaining

possessing or acquiring:(a) power of revocation of trust;(b) power of disposition of property;(c) power to amend trust;(d) any benefit from time of disposition;(e) power to remove or appoint a trustee or protector;(f ) power to direct a trustee or protector;(g) a beneficial interest.

13D. Enforcement of Foreign Judgments: This section prohibits the enforcement ofa foreign judgment to respect to an IT and forces a litigant to commence ac-tion de novo in a Cook Island Court. This section provides that notwithstand-ing the provisions of any rule of law or equity, no proceedings for theenforcement of recognition of a foreign judgment against an IT, a set t lor, atrustee, a protector, a beneficiary or any person appointed by an instrumentin connection with an IT or against the property of an IT shall be entertainedby any court in the Cook Islands if that judgment is based upon any law in-consistent with the provisions of the IT or if that judgment related to a mattergoverned by the law of the Cook Islands.

13G. Governing Law: This section provides that regard shall be given to the termsof the set t lement. A term expressly selecting the law of the Cook Islands isconclusive.

Figure 14.1 Advantages of foreign jurisdiction trust—Cook Islands.


managing general partner, you own 1 percent, and you and/or yourfamily, as limited partners, own 99 percent of the partnership. You, asmanaging general partner have 100 percent management control of thepartnership, including the right to buy and sell assets and the power todetermine whether or not the partnership distributes income to the lim-ited partners. The limited partners have no say in the day-to-day man-agement of the assets.

STEP 3 A gift of the 99 percent limited partnership interest is madeto a family international trust. Generally, the trust’s only asset will be

Figure 14.2 Four-step asset protection plan using a foreign trust.

FamilyLimited

Partnership

FamilyInternational

Trust

Trustees (3)

U.S.U.S.

Cook Islands

Protector(May be yourself)

Veto Power over TrusteesCan Hire and Fire Trustees

1% General Partner

100% Control PlusRights to Income

99% Limited Partner

No ManagementRights

Beneficiaries (Family)

Assets


the interest in the family limited partnership. The trust will have nosay in the management of the partnership. There are no gift tax conse-quences incurred by this transfer.

English law defines the protector as one who acts on behalf of thebeneficiaries. The protector, who can be yourself, has veto power overthe trustee’s activities regarding investments and distribution, and theprotector has the authority to replace any or all of the trustees at anytime and the authority to appoint the replacement trustees.

The family international trust is a grantor trust with: two U.S. trustees(personal friends, lawyer, CPA, not yourself or beneficiaries) and oneforeign trustee, such as a trust company located on Cook Islands.

Beneficiaries are spouse, children, relatives, or others includingcharities.

STEP 4 If a lawsuit or serious creditor problem occurs, depending onthe timing and seriousness of the claim, we recommend the dissolutionof the partnership to allow the trustee to control the assets. After thelawsuit or creditor problem is settled or otherwise reconciled, the clientcan reestablish rights of direct control over the assets by merely reestab-lishing the family limited partnership.

If you should wish to remove assets from the plan, there are severalmethods of doing so. Among the simplest is to merely appoint assets toyour spouse. There are other methods available to remove assets fromthe plan if you are single.

SUMMARY

In any asset protection plan, the primary goal is to create an environ-ment where assets can be utilized to their fullest extent while at thesame time receiving the maximum protection from frivolous and im-moral lawsuits. By legally removing assets from the reach of creditors,you will be able to settle or discharge existing or potential liabilities onterms advantageous to you.

The family limited partnership gives you the vehicle to legally trans-fer assets. Other entitles, such as corporations and trusts are costly andtime consuming. A wrong move can expose your estate to the whims ofcreditors. Professional fees could add up to more than the value of theassets. Putting aside all these headaches, these other entities still don’tcome close to offering the protection a family limited partnership does.

207

Glossary

acceleration clause A stipulation in a mortgage that provides for theentire principal and interest to become immediately due and payable ifownership is transferred or some other stipulated event takes place.

acceptance The seller agrees to enter into a contract and to be boundby its terms. The buyer must receive notice of acceptance before it be-comes legal.

accrued depriciation Depreciation that has been incurred since theacquisition of an asset. The difference between the cost of replacementnew as of the date of the appraisal and the present appraised value ofthe property.

accrued interest Interest that is earned but not yet received.

acknowledgment A declaration that is part of a document made be-fore an authorized person (usually a Notary Public).

active income Income earned by one’s labor compensated for in salary,wages, commissions, fees, or bonuses. Also called earned income.

add-on interest The amount of interest calculated on the originalprincipal that is added on.

adjustable rate mortgage (ARM) A mortgage note that allows a lenderto adjust the interest rate at periodic intervals. The rate change is mostcommonly limited to the movement of a regular approved index.

bgloss.qxd 4/5/04 11:40 AM Page 207

208 GLOSSARY

after-tax cash flow Before-tax cash flows less income taxes paid as aresult of owning the property in question or plus income taxes saved(tax shelter) as a result of owning it.

agent One who is legally authorized to act on behalf of another person.

agreement for sale A written instrument in which the parties agreeto sell under certain terms and conditions.

alienation clause A condition in the note that requires payment of theentire loan balance upon sale or other transfer of interest in property.

all-inclusive deed of trust (AITD) Purchase money trust deed that issubordinate to but wraps the original indebtedness or trust deeds onthe property.

American Land Title Association (ALTA) A national association oftitle insurance companies, and related real estate professionals.

amortization Periodic reduction of the principal debt. The systematicand continuous payment of an obligation through installments untilsuch time as the debt has been paid off in full.

amortized loan Payment of both the interest and principal by seriesof level payments that are equal or nearly equal, without any specialballoon payment prior to maturity.

appraisal A report from a qualified professional as to the value of anasset using the cost, income, and market approach.

appraised value A determination of the value of an asset by an ap-praiser based upon a study of pertinent data.

appraiser One qualified by education, training, and experience to es-timate the value of real and personal property.

arbitration The determination of a dispute by a qualified disinter-ested third party usually a judge.

arbitration clause Clause in a contract that provides a procedure forsettling disputes between parties to be decided by an independent ar-bitrator rather than by a court of law.

asking price The price the seller is offering his property to the public.

assessment The value placed on property by the government for taxa-tion purposes. It could also mean a levy against property for a specialpurpose, such as a school assessment.

assignee The entity to whom an agreement or contract is assigned.

assignment The transfer of rights in a contract to another.


GLOSSARY 209

assumption fee The fee paid to a lender to assume a mortgage.

assumption of mortgage The buyer assumes the existing mortgageand primary liability for the payments.

at-risk rule IRS rule that limits the amount of losses that may be de-ducted based on your actual liability.

authorization to sell A contract in which a principal employs anagent to perform certain acts.

Usually it authorizes the agent to secure a buyer that is “ready, will-ing, and able” to purchase the property at the price and terms that it isoffered for sale rather than to sell the property.

backup offer An offer made to purchase or lease a property that issubmitted to the owner with the understanding that the owner alreadyaccepted an offer on the property. The seller may accept the backupoffer with the condition precedent that the first sales transaction fails tobe completed. (See tender.)

balloon mortgage A mortgage that has a lump-sum payment at thematurity date.

balloon payment A lump-sum payment usually paying off the debt.

bill of sale A written document used to transfer title to personalproperty.

binder, insurance A written evidence of liability or title coveragethat’s for a limited time.

boot Money received and/or a reduction of loan liability or value re-ceived in an IRC § 1031 Exchange.

capital gain The profit realized from the disposition of an asset to bereported to the IRS.

capitalization A computation that gives the present value of an assetbased on the desired rate of return of a series of anticipated future in-stallments of income.

cash basis taxpayer Reporting to the IRS on income when receivedand deductions and expenses when paid.

cash flow Money received from your investment(s) after paying allexpenses and loans.

certificate of title A proclamation furnished by title company thatstates the title to property is legally vested in the present owner.

chattel Personal property.


210 GLOSSARY

closing costs Fees and costs incurred in the transfer of or refinancingproperty, such as escrow fees, title insurance premiums, conveyancetaxes, loan prepayment penalties, termite inspection charges, attorney’sfees, and so on.

cloud on title An unsatisfactory recorded impediment on the prop-erty shown by a title search that may affect the transfer of title.

co-insurance A sharing of insurance risk between insurer andinsured.

collateral Assets pledged as security. Example, as the real estate se-curing a mortgage.

commission An agent’s compensation (fee) for acting on behalf of hisprincipal.

contract of sale Agreement between the buyer and seller in whichthe buyer agrees to buy under certain terms and conditions and selleragrees to sell. To be enforceable, it must be in writing and properly ex-ecuted by both parties.

cost approach A valuation method used to determine the replace-ment cost of an asset.

debt coverage ratio The ratio of effective annual net income to annualdebt service.

declining balance method A method of depreciation whereby anasset is written off more rapidly in the early years.

deed A written instrument to convey ownership of real property.

deed of trust A security instrument used to convey title to a trusteeas collateral for the payment of a debt. The trustee has the power to sellthe property in the event of default and to reconvey title when debt ispaid in full.

deposit receipt An acknowledgement that earnest money has beenreceived to purchase real property.

depreciation Generally, it means a loss of value in real property dueto age, physical deterioration, or functional or economic obsolescence.

discount The value of a note for less than its face amount.

double escrow A situation where buyer sells the property while it isstill in escrow.

downpayment The difference between the sale price of real estateand the mortgage amount(s).


GLOSSARY 211

due diligence Basically, it means that you find out all about the prop-erty before you purchase it, which includes physical inspection and in-spections of books and records.

earnest money Money paid as evidence of good faith or actual intentto complete a transaction, usually forfeited by willful failure to com-plete the transaction.

economic life The estimated period of time during which a propertycan be utilized profitably.

eminent domain The right of a government to take private propertyfor public use.

encroachment Wrongful extension of an improvement that intrudesillegally on another’s property.

equity participation A loan in which the lender not only receivespayment on the loan but also acquires an interest in the property.

escrow A third party, acting as the agent for the buyer and the sellercarries out instructions for both.

escrow instructions In real estate it is a contract between both buyerand seller that instructs the escrow agent.

estoppel A legal term in which a person is barred from denying a factbecause of his previous acts because the denial would be inconsistenthis representation.

exclusive right to sell listing Agreement employing a real estate bro-ker to act as agent for the seller. It doesn’t matter who sells the prop-erty. The listing broker is entitled to a commission if the property issold during the duration of the listing period.

fair market value The price at which the seller is willing to sell and thebuyer us willing to buy, each of whom has a reasonable knowledge of allpertinent facts and neither being under any compulsion to buy or sell.

fee simple The greatest possible interest a person can have in realestate.

first right of refusal A right given by the seller to a potential buyerto purchase property before he offers it to other buyers.

foreclosure A legal procedure taken by a lender to take back theproperty.

gift deed Deed for which consideration is love and affection.

grantee A person to whom a grant is made. The purchaser.


212 GLOSSARY

grantor The person conveying an interest in real property. The seller.

gross income Total income from a property before any expenses arededucted.

gross rent multiplier An index used to compare rental properties. Itis the relationship between the gross rental income and the sales price.

highest and best use The use that will produce the highest propertyvalue.

holdback That portion of a loan that will be held back until some ad-ditional requirement, such as rental or completion, is attained.

income approach to value An appraisal technique used determinereal property value by capitalizing net income.

installment sale The sale in which the payments for the property aremade over a period of time.

insurable title A condition whereby the title insurance company iswilling to issue a policy of insurance.

interest The cost for using money.

internal rate of return (IRR) Method of calculating the present valueof the return on an investment based on the discounted rate of futurecash flows.

involuntary lien A lien put on real estate without the consent of anowner. Examples include taxes, special assessments, federal income taxliens, judgment liens, mechanics liens, and materials liens.

joint and several note A note signed by two or more persons, each ofwhom is liable for the full amount of the debt.

joint tenancy An equal undivided ownership of property by two ormore persons, the survivors to take the interest upon the death of anyone of them.

judgment proof An entity that has no assets that can be sought to sat-isfy a court judgment.

late charge A penalty charge imposed on the borrower for failure topay a regular installment when due.

lease option A lease that provides that the tenant has the right topurchase the property under certain conditions.

letter of credit A letter authorizing a financial institution to honorthe issues credit.

leverage Using borrowed money to purchase real estate.


GLOSSARY 213

like kind property Property qualifying for an IRC § 1031 Exchange.Like kind property is any real property exchange for real property.

limited partnership An entity that has one or more general partnerswho are fully liable and one or more limited partners who are liableonly for the amount of their investment.

lis pendens A notice recorded in the official records to indicate thereis a pending suit affecting the real estate.

loan-to-value The relationship between the mortgage and the ap-praised value of the security.

market data approach to value The value of real estate is based on ac-tual prices paid in market transactions.

market value Highest price at which a property will bring in a com-petitive and open market, with knowledgeable buyers and sellers.

mechanics lien A recorded judgement against the property put on bybuilding contractors, laborers, and suppliers who have not been paid.

member appraisal institute (MAI) The highest professional designa-tion awarded by the American Institute of Real Estate Appraisers.

mortgage broker An individual who brings the borrower and lendertogether.

mortgagee An entity to whom property is conveyed as security for aloan.

multiple listing An exclusive agreement to sell, taken by a member ofan organization of real estate brokers.

negative cash flow Paying more cash expenditures of an income pro-ducing property than cash receipts.

net income The difference between effective gross income and the ex-penses, excluding debt service and depreciation.

net rentable area The rentable square footage of a building, exclud-ing halls, lobbies, stairways, elevator shafts, maintenance areas, andso on.

non-recourse note A debt instrument that restricts the lender to relysolely on the property for repayment.

obsolescence The loss of value of a property because of going out ofstyle or becoming less suitable for use, or by other economic influences.

operating expenses Usually refers to all expenses of running a prop-erty, except depreciation and mortgage payments.


214 GLOSSARY

option A right to purchase, sell, or use property at a stated price dur-ing a stated period of time.

passive activity income A tax term that refers to the amount of timespent in operating a trade or business. If a taxpayer does not materiallyparticipate, the income is considered passive.

point A loan fee of one percent of the principal amount of the loancharged by the lender.

possession The act of constructively occupying a property that givesnotice to others that the party in possession may have certain rights tothat property.

potential gross income The highest amount of revenue a propertywould produce if fully rented at market rates.

preliminary title report A title search by a title company prior to is-suance of a title binder or commitment to insure.

prepayment fee An amount paid to the lender for the privilege ofprepaying the loan.

principal One of the parties to a transaction of one who hires an agent.

proforma statement A projection of performance of real estate withina period of time based on estimates and assumptions.

promissory note A promise to pay a specified sum at a specific date.

property management The act of operating property on a day-to-daybasis.

quit claim deed A transfer of rights to property that contains no rep-resentation or warranty as to the quality of the title being conveyed.

real estate owned (REO) Ownership of real property of lending in-stitutions acquired for investments or as a result of foreclosure.

real property Usually, land and appurtenances (that which by law isimmovable).

Realtor® Registered trademark of the National Association of Real-tors. A broker who is an active member in a local real estate board af-filiated with the National Association of Realtors.

recognized gain The gain made in a property exchange that is subjectto taxation.

refinancing The repayment of a loan using the proceeds of a newloan with same property as security.


GLOSSARY 215

rental concession A marketing strategy to give up part of the adver-tised rent in an effort to attract tenants.

replacement cost An evaluation of real property based on cost of con-struction using modern materials and according to current standards,design, and layout.

reproduction cost Replacements using the exact replica, having thesame quality of workmanship, design, and layout.

rescission The cancellation of a contract by the operation of law.

restrictive covenant A provision in the deed limiting use of theproperty.

right of survivorship A joint tenant has the right to acquire the inter-est of deceased joint tenant(s).

secondary mortgage market A market place where existing mort-gages are bought and sold.

short-rate A method of calculating a lower premium on an insurancepolicy for a short period of time.

standby commitment An agreement from the lender to loan withspecified terms for a specified amount of time.

subject to mortgage Purchasing property subject to the existingmortgage. The seller still is held for any deficiency.

subordination Allowing your note to become inferior to the interestof others. Subordination also applies to leases, real estate rights, andother debt instruments.

supply and demand The basis of determining valuation of a property.The net effect of either too many inventories or to many people want-ing the product.

tax lien A recorded demand against property for the amount of un-paid taxes.

tax shelter Refers to advantages of taking certain deduction to reducetax liability.

tenancy by entirety The joint ownership of property that is viewed asone person under common law that provides for the rights of survivor-ship.

tenants-in-common A type of ownership created when real or per-sonal property is granted to two or more persons without the right ofsurvivorship.


216 GLOSSARY

title The evidence of ownership in property in whom the legal estateis vested and the history of ownership and transfers.

title insurance policy An insurance policy usually issued by a titleinsurance company in which they agree to pay certain claims madeagainst legal ownership.

trust deed Legal document by which real property is used as a guaran-tee for the repayment of a loan. The trustee, not the borrower, is grantedtitle to the property and has the power of sale, which the trustee can ex-ercise upon default by the trustor (borrower).

usury Charging a greater rate of interest than is permitted by statelaw.

vacancy and rent loss Unrented rent-ready rental units. Rent lossrefers to units that can’t be rented because they are not physicallyready to rent or because of the tenant’s inability to pay.

vacancy factor The percentage of unrented income over the grosspossible rental income.

warranty deed An instrument in which the grantor or seller warrantsor guarantees that good title is being conveyed.

will A person’s written declaration expressing how assets are to bedistributed upon their death.

without recourse A loan that protects the endorser from liability inwhich the lender can only look to the property for repayment.

wrap-around See all-inclusive deed of trust.


217

Apartment Age Magazine621 S. Westmoreland Ave.Los Angeles, CA 90005-3981

Apartment Finance Today220 Sansome, Floor 11San Francisco, CA 94104

Apartment Management Magazine

15502 Graham St.Huntington Beach, CA 92649

Apartment News12822 Garden Grove Blvd., Ste. DGarden Grove, CA 92843-2010

Apartment Owner15025 Oxnard St.Van Nuys, CA 91411

Apartment ReportP.O. Box 1150Novato, CA 94948

Commercial InvestmentReal Estate Expense Analysis:Conventional Apartments/Expense Analysis: FederallyAssisted Apartments/Journalof Property Management

430 N. Michigan Ave., Ste. 800Chicago, IL 60611-4092

Journal of Real Estate Finance andEconomics

101 Philip Dr., Assinippi PkNorwell, MA 02061-1615

Multi-Unit Report5253 Yonge St., Ste., 1000Toronto, ON M2N 6P4 Canada

National Real Estate InvestorNational Real Estate Investor Source Book

4200 S. Shepherd Dr. #200Houston, TX 77098

Apartment Periodicals

218 APARTMENT PERIODICALS

National Register of CommercialReal Estate

1055 Washington Blvd.Stamford, CT 06901-2216

Professional ApartmentManagement

149 5th Ave., 16th Fl.New York, NY 10010-6801

Property Tax Service/Real Estate Review

610 Opperman Dr.Eagan, MN 55123

Real Estate Economics350 Main St.Malden, MA 02148

Real Estate Finance & Investment488 Madison Ave. 12th Fl.New York, NY 10022

Real Estate Finance Today1919 Pennsylvania Ave. NWWashington, DC 20006

Real Estate Forum111 8th Ave., Ste. 1511New York, NY 10011-5215

Real Estate News3550 W. Peterson Ave., #100Chicago, IL 60659-3320

Real Estate Tax Digest201 Mission St., 26th Fl.San Francisco, CA 94105

Units201 N. Union St., Ste. 200Alexandria, VA 22314-5603

Urban Land1025 Thomas Jefferson St. NW,

Ste. 500 WestWashington DC 20007-5201

219

AAA corporate bonds, 2Acceptance letter, 93–95Accountants, working with, 48–49Accounting method, 169–170Accrual method of accounting, 168, 169Accrued interest, 26Acquisition cards, 70Active participation, 167

establishing, 151–152status, 150–151

Advantages of tenants-in-common, 178active voice in management, 178ease of transferability, 179economy of scale, 179low down payment, 178low set-up costs, 178no mortgage or qualifying restrictions,

179private group, 179tax advantages, 179

Advertisements, successful, 69, 158–159Agent, 49, 50, 68–70, 74, 77, 156Agreement of introduction, 87Agreements, rental, 123All-events test, 168–169All-inclusive trust deed (AITD), 131–132American Land Title Association

(ALTA), 90Analysis, financial set-up sheet, 72–75

Analytical approach to apartmentlocating, 60–61

building permits, 61, 62employment, 62–63historical data, 61household income, 63median home prices, 63–64number of households, 63rental rates, 64–65vacancy factors, 64

Annual budget, 147Apartments:

advantages over other types of realestate, 12–13

best investment, 22–23buildings:

cycles, 57demands for, 56–57locating, analytical approach, 60–65steps to locating, 24–36

economics, 58–60investor friendly, 17operating expenses, 76

insurance, 146property management, 24, 60, 76taxes, 76, 146utilities, 76, 126, 145–146

vacancies, 24Applications, rental, 123

Index

bindex.qxd 4/5/04 11:41 AM Page 219

220 INDEX

Appraisal techniques, 98–99Appraiser, 52, 98–99Arbitration, 48, 90–91, 192“As is” property, 138Assessed valuation, 74Assets:

accumulation, 1, 7attachable, 192conservation, 1, 7protection plan and foreign trust, 203,

205–206transfers, 193

Attachable assets, 192Attention, getting seller’s, 80–81Attorney, finding, 47–48

Balloon payment, 86Billings, avoiding unnecessary, 42–43Binding arbitration, 48Blue chip stocks, 2Boot, 172–173Bottom fishing, 55–57Broker information, 77Bruss, Robert, 131, 132Budget, annual, 147Building:

inspector, 50, 52permits, 61, 62physical appearance of, 144–145size and profit potential, 13–14

Business cycles, 12Buyers:

determining if they are real, 160looking for, 158market, 93overly informative, 157track record, 160

Buying and selling, rules for, 55

California Uniform Partnership Act, 198Capabilities, financial, 5Capital gains:

and losses, 165paying, 175and taxes, 171

Capitalization rate (CAP rate), 73, 76, 99,120

Cash f low:of example property, 27–36and financing, 84, 130, 134and property analysis, 121, 126and scheduled repairs, 144tied to commission payments, 164

“Cashed out,” 72Center for Real Estate Studies, The, 27,

65, 120

Certified Commercial InvestmentMember (CCIM), 49

Claims, protection from existing, 203Closing the sale, 160–161Commissions, 90–91

based on sliding scale, 155payments and cash f low, 164real estate, 156saving on, 50split, 77

Companies:escrow, 49, 139–140title, 49

Comparable sales data (Comps), 99Compound interest vs. simple interest, 132Computer programs, 120–122Conflicts of interest, 43, 44, 46, 52, 152Consent, partners, 199–200“Construction bubble,” 56Consultant reports, written, 43Consultants:

accountant, 48–49appraiser, 52attorney, 47–48building inspector, 50–52choosing, 40–42employing, 39–53escrow/title companies, 49getting the most, 42–44loan broker, 52–53locating helps, 40property manager, 44–47saving money, 49–50team approach, 39

Contingency fee arrangement, 191Contracts:

getting out legally, 160legally binding, 91–92structuring to avoid litigation, 48

Conveyances, 194, 195Cook Island, 203Cosmetic remodeling, 154CoStar Group, 99Cost estimates, written, 43Cost segregation analyst, 166Counteroffer, 92–93, 95, 140–141Court cases:

Centurion Corp v. Croker NationalBank, 197, 198, 199

Goodwin v. Elkins & Co., 184, 185Horbach v. Hill, 194Hurlbert v. Shackleton, 193Leyva v. Superior Court, 184Matek v. Murat, 184, 185People v. Schock, 181re Oberst, 194


INDEX 221

SEC v. Glen W. Turner EntertainmentInc., 185

SEC v. W. J. Howey Co., 181, 184Silver Hills Country Club v. Sobieski,

181Tupper v. KROC, 200Williamson v. Tucker, 184, 185

Covenants, restrictive, 133Covering letter, 81, 91–92Creditors:

asset protection plan, 203, 205–206eliminating or reducing cost of

personal liability insurance, 201estate planning, 202hampering, 200negotiating a settlement, 202paying yourself without paying

creditors, 200–201protecting yourself, 203protection for family-limited

partnership, 202rights of, 196stumbling blocks, 201–202

Current operating month, 147Cycles:

of apartment buildings, 57of business, 12

Data approach, market, 98–99Deficiency judgments provisions,

132–133Demands for apartment buildings, 56–57Demographics:

factors, 56–57indicators, 11

Dent, Harry, 14Deposits:

check, 81, 84escrow, 140

Depreciation:catch-up, 171deduction, increasing, 165–167

Depressed market, 56Disbursements, 146–147Distressed properties, 36Down-market strategy, 98Down payment, 83–84, 136–137Drive-by inspections, controlling, 158Due diligence, 8, 93, 95Due-on-sale clause, 86

Echo Boomers and real estate, 14–17Economic obsolescence, 144Economics:

of apartments, 58–60of scale, 24

80 percent rule, 80Emotional capabilities, 5Employment:

figures, 62–63trends, 56

Equity, 156gross, 72investments, 10

Escape clause (purchase offer), 85–86,160

Escrow:closing:

to avoid collecting late rents, 139period, 89possession before, 138

companies, 49deposits, controlling, 140fees, 139independent companies, 139–140period, 88, 90

Estate planning, 6, 197, 202Exchanges, 173–174Expenses:

analyzing, 126apartment operating, 76income/expense classifications,

defining, 147Experian Real Estate Information

Services, 21Express warranties, 89

Fair consideration, 195Family international trust, 206Family-limited partnership (FLP), 192,

193, 197–200, 203, 206partner’s consent, 199–200protection from creditors, 202restrictions, 200

Fee vs. commission, 43Feel-and-touch analysis, 126–127Fees:

contingency arrangement, 191controlling consultants, 42escrow, 139negotiation, 46, 49–50, 139–140“one-way” system, 192property management, 45–46

Financial analysis, set-up sheet, 72–73

assessed valuation, 74capitalization rate, 73gross rental multiplier, 73–74legal description, 74–75

Financial capabilities, 5Financial independence, meaning of, 7Financial indicators, 11


222 INDEX

Financial plan, up to age 35, 1–2, 4Financial statement, 81, 93, 160Financing, 84–85

all-inclusive trust deed, 131–132and cash f low, 84, 130, 134lease option, 132strategies, 131–132“subject to” loan, 131

Foreclosures, 19–22, 36Foreign asset protection trust (APT), 203Fraudulent conveyance, 192–193Functional obsolescence, 144Furniss, Daniel, 21Future market value, 52

Gale Directory of Publications andBroadcast Media, 67

Gift, tax deductible, 172Greenberg, David M., 184, 197Gross equity, 72Gross income, 90Gross multiplier approach, 99Gross rental income. See Income, gross

rentalGross rental multiplier (GRM), 73–74Grouping method, 165Group investing, 23–36Group size, decreasing, step to locating

apartment buildings, 28–35Growth-oriented no-load mutual funds,

2Growth rate, 97, 98

“Hold-back” attitude, 4Households, number of, 63Howey test, 181, 184

Implied warranties, 89Improvements, land, 174Income:

expense classifications, defining, 147gross rental, 75, 90household, 63increasing rental, 145property, renovating, 154schedule of, 75tax liability, 163

Independence, financial, meaning of, 7Indicators, financial, 11Indiscriminate offering, 184Individual retirement accounts (IRAs), 2Inf lation rates, 5Insolvency, 194–195Inspection:

physical, 85, 126–127, 161reports, 86, 126, 145

Inspector, building, 50, 52Installment sale, 131, 164, 165Institute of Real Estate Management

(IREM), 26, 72, 146Insurance:

eliminating/reducing cost of, 140, 146,201

life, 2title, 90

Intangible personal property, 165Interest:

accrued, 26, 66, 168–170compounding, 132deduction, 76, 165, 168–169rates, 60, 72, 134, 135, 157, 165, 189,

198–199variable rate, 157

Internal rate of return (IRR), 64, 97,122–123, 167

Internal Revenue Service (IRS), 10, 74,150, 163–175

International Trusts Act (ITA), 203Introduction, agreement of, 87Investing:

between ages 35 and 50, 2conquering fears of, 6–7new approach to, 19–37

Investments:aggressive, 2in apartments, reasons to, 22–23equity, 10evaluating, 97–98getting IRS to pay, 134interest, 170no-risk, 5passive, 9periods, life’s, 1–2, 5, 6philosophy of, 7strategy, for over age 50, 5types of, 2, 6, 9, 22

Investor friendly, apartments, 17

Judgment creditor, 192Judgments, protection for, 193–194

Kammrath & Associates, 26Key components of written offer, 81,

83–85

Land cost, depreciating, 174Lawsuits, 191–206Leads, source for, 69Leases, 132, 173Legal description, of property, 74–75Lenders, making them work for you,

68


INDEX 223

Letter of acceptance, 93–95Leverage, 136

degree of, 10using, 157

Liabilities incurred, 193Liability coverage, reducing, 2Liability insurance,

eliminating/reducing cost of, 201Life insurance, 2Like-kind exchanges, 173Limitations and constant change,

134–135Limitations of interest deductions, 170Limited liability companies (LLC), 197Limited partnership, 167, 177, 179, 193,

198Lis pendens, 160Litigation, avoiding, 48Loan:

brokers, 52–53determining the cost of, 133documents, 85–86information, 76–77

Local economic conditions, 27, 32, 35, 56,68, 141, 146

Locations, evaluating, 56Locating consultants, helps, 40Losses, unlimited real estate, 173

Management:contract, 137plan, objectives of, 143–146poor, 130

Market:data approach, 98–99rebounds, 60survey, 147value, 52, 76, 91, 93, 99

Marketing plan, 145, 155Marshall & Swift, 61, 98Median home price, 30, 63–64Member appraisal institute (MAI)

appraisal, 157Metropolitan Statistical Areas (MSAs),

25, 56Modified accelerated cost recovery

system (MACRS), 174Mortgage:

adjusting payments, 134assumed, 131

Motivation, to sell, 68, 72Multiple listing services (MLS), how it

works, 50

Narrative, 147Negotiating, mistakes to avoid, 136

Negotiation:fees, 46, 49–50, 139–140purchase and sale, 52, 68, 74, 80, 83, 92,

130–132, 134–138, 139–142, 159Negotiator, becoming a, 129–142Net operating income (NOI), 135Nonsecurity:

Howey test, 181, 184marketing, 186–187protection, 187risk capital test, 184–185supply of buyers, 187transaction, creating, 181Williamson test, 185–186

Note, making it more valuable, 156–157Notice of default, 21

Obsolescence, 144, 152Offers, responding to, 159“One-way” fee system, 192Opening statements, set-up sheet:

gross equity, 72have and wants, 72location, 70motivation, 72

Operating expenses:apartment, 76reducing, 145–146

Operating statement, 146–147“Overly informative” buyer, 157

“Paralysis by analysis,” 6Partnership:

agreement, 185, 200family limited, 192, 193, 197–200,

202–203, 206limited, 167, 177, 179, 193, 198

Passive investments, 9Payback periods, 134Payments, late mortgage, 133–134Performance:

of apartments, comparing to others, 146economic, 168–169

Periods:escrow, 88, 90payback, 134wealth-building, 7

Permits, building, 61, 62Personal property items, 166–167Peters, Tom, 7Philosophy of investment, 7Physical inspections, 85, 126–127, 161Physical obsolescence, 144Planning, financial, 1–2, 4Points, 52–53, 84, 133Population, 57–59, 126–127


224 INDEX

Position, transfer of, 86–87Present values, 133Price strategies, 135–136Profiles, tenant, 123Profit potential and building size, 13–14Profits, taxes on, 136Property:

“as is,” 138best time to sell, 153–154converting real into personal, 165–166getting it ready for sale, 154legal description of, 74–75locating good, 67–78maintenance of, 154marketing, 153–161methods of analyzing, 98

capitalization rate method, 99, 120comparable sales data (comps), 99computer program, 120–122gross multiplier approach, 99qualified appraisers, 98–99

personal, 166–167profiles, 90real, 165–166tax expenses, reducing, 146techniques for analyzing:

down-market strategy, 98expenses, 126feel-and-touch, 126–127internal rate of return, 122–123key figure, 97–98methods, 98–99, 120–122revenue assumptions, 123, 126

Property management:agreement, 46–47, 150company, 143, 158fees, controlling, 45–46firms, 26–27

Property manager, 44–47finding, 44hiring, 24managing your, 143–152procedure manuals, 45what to expect, 45

Protector, definition, 206Purchase:

offers of, 81, 83–85, 91price, 83

Purchase offer, written:acceptance letter, 93–95dealing with sellers, 92–93design of, 81–9180 percent rule, 80getting seller’s attention, 80–81legally binding, 91–92

Purchasing power, 97

Qualified owners, 167

Rates of inf lation, higher, 5Real estate:

broker, 49, 50, 77, 156, 161consultant agreement, 187controlling investment risk, 9–10investment broker, 49licensee, 68, 155market, 30multifamily, 10–11unlimited losses, 173

Real estate owned (REOs), 68Real property, 165–166Realtors National Market Institute

(RENMI), 49Receipts, 146Recording meetings with consultants,

42–44Records, 85Reid, John T., 163Relations, tenants, 145Rental:

agreement, 123applications, 123demands, 14income, 24, 75rates, 64–65

future, 25raising rates, 138–139

Repairs:and cash f low, 144credits, 137and protection from, 137–138

Replacement costs, 97, 98Reports, property manager, 146–147Research, step to locating apartment

buildings, 25–28Residential income property, 16Restriction, partnership agreement, 200Return on investments, 97Revenue assumptions, 123, 126Reverse exchanges, 174Revised Limited Partnership Act, 198,

200Risk:

controlled, 4–6degree of, 2, 122and the IRR, 122–123

Risk capital test, 181, 184–185

Sale, closing, 160–161Sales tax problems, 139Security transactions, pitfalls of,

180–181Self-marketing, 156


INDEX 225

Seller’s remorse, handling, 141Seller’s warrant, 89Selling price, determining, 157–159Settlement, negotiating, 202Set-up sheet, 70–77

conservative, 157–158financial analysis, 72–75opening statements, 70, 72other income, 76–77reading, 70rental income, 75–76

Sleep growth, 98Sole investing, step to locating

apartment buildings, 35–36“Solvency” test, 193Statements:

financial, 81, 93, 160operating, 146–147

Strategies, financing, 131–132all-inclusive trust deed, 131–132lease option, 132price, 135–136“subject to” loan, 131tax, 172

Strong buyers market, 93“Subject to” loan, 131, 133Supply and demand, 14

Taxable income, ways to lower, 163–164

group income and expenses, 164–165

spreading income over time, 164spreading income over various

entities, 164Tax advisors, 132, 134, 136, 164, 165,

175Tax-deferred plans, 2Taxes:

on capital gains, 171defer paying, 170–171reducing, 10

Tax-free bonds, 6Tax impact, tenants-in-common, 180Tax planning, goal, 163Tax reform loophole, 167–168Tax strategies for landlord/leasee, 172Tax write-off, qualifying for, 150–152Team approach, advantages of, 39Tenants:

profiles, 123relations, 145

Tenants-in-common (TIC), 167agreement, 189ownership:

advantages of, 178–179creating nonsecurity transaction,

181, 184–186features, 177–178marketing nonsecurity, 186–187pitfall of security transactions,

180–181profits, 189tax impact of, 180

Title companies, 49Title insurance, 90, 140Title report, 74, 85, 89, 158Track record, 81Transfer title, 89Trust deed, 137

Uniform Fraudulent Conveyance Act(UFCA), 193, 194–197

Uniform Fraudulent Transfers Act(UFTA), 193

Uniform Limited Partnership Act, 198Unit mix, 26“Up property,” 173, 175

Vacancy:in apartments, 24delinquencies, 147factors, 64rate movements, 25

Valuation, assessed, 74Value:

market, 52, 76, 91, 93, 99present, 133provisions and conditions, 156–157

Variable interest rate, 157

Walk through, 161Warranties, 89Weak buyers market, 93Weak market, 55, 56Wealth building, 1, 7Wealthy, becoming, 4–6Williamson test, 185–186Wrap-around loan, 131Write-off, 10, 131, 150–152, 165, 167, 179Written cost estimates, 43Written plan, 143

Yield, 23, 132


For More Information onThe Center for Real Estate Studies

Contact

The Center for Real Estate StudiesP.O. Box 3315

Palos Verdes, California 90274(800) 955-3135